XLI: Stock Performance Of Boeing Will Impact Its Fund’s Performance In H2 2019 – Industrial Select Sector SPDR ETF (NYSEARCA:XLI)

ETF Overview

The Industrial Select Sector SPDR ETF (XLI) owns a portfolio of U.S. large-cap stocks in the industrial sector. The ETF basically tracks the industrial sector stocks in the S&P 500 Index. XLI has outperformed the S&P 500 Index in the past 10 years and is currently trading at a slight discount to the S&P 500 Index. However, we are likely in a late cycle environment and a recession may not be too far away. In this late stage phase, XLI will likely underperform. Therefore, we think it may be wise to wait on the sideline.

Data by YCharts

Fund Analysis

A rally in Boeing’s stock in H2 2019 may be positive for XLI

XLI has outperformed S&P 500 Index in the past 10 years. It delivered a return of 251% vs. S&P 500 Index’s 221%. However, XLI has not performed well since the beginning of 2018. Since 2018, XLI only delivered a return of 2.3%. This was much lower than S&P 500 Index’s 11.1%.

Data by YCharts

We believe this underperformance was due to several underdog stocks in XLI’s top 10 holdings. For example, Boeing (BA) and 3M (MMM) have not done well lately. Currently, Boeing represents nearly 9% of XLI’s portfolio and 3M represents about 5.3% of the portfolio. If 737 Max jets can resume flight before the end of the year, we may see a rally in Boeing’s stock in the second half of 2019. This will likely result in better fund performance for XLI.

Source: SPDR Website

How XLI will perform in different stages of the economic cycle

Companies in the industrial sector tend to perform well in the initial stage of the economic cycle (see bottom left chart). This is because most of its customers have reduced their inventories significantly during an economic recession. As inventory levels decline, businesses will start to order more stocks from industrial companies. This will translate to higher sales and boost these companies’ profits. Therefore XLI will perform well in the initial stage of the cycle. As consumer confidence gradually improves, companies in the industrial sector will also experience growth.

Source: Fidelity: The Business Cycle Approach to Equity Sector Investing

As the economic cycle matures, companies in the industrial sector will generally experience a deceleration in growth rate. As soon as the economy falls into a recession, these companies will experience a decline in orders and sales as their customers may deal with more inventories. Therefore, XLI will likely underperform in an economic recession (see bottom right chart).

Source: Fidelity: The Business Cycle Approach to Equity Sector Investing

Where are we in the current economic cycle?

The current economic cycle has been well into its 10th year. The economy in the United States continues to run at a full capacity. In Q1 2019, U.S. GDP growth rate re-accelerated to 3.2%. In the same time, its unemployment dropped to 3.6%. This is the lowest we have seen since 1969. However, several leading economic indicators are pointing towards a weakening economy. In the U.S., ISM Manufacturing PMI fell to 51.7 in June 2019. This is the weakest pace of expansion since October 2016.

ISM Manufacturing PMI in the U.S. (Source: Trading Economics)

Since most of XLI’s portfolio of stocks have a sizable business outside the U.S., we also need to take a look at the economic conditions globally. As can be seen from the chart below, global PMI fell to 51.2 in May 2019. This was lower than January 2018’s 54.5.

Global Manufacturing PMI (Source: Trading Economics)

Both charts above point to declining business confidences in the U.S. and globally. If PMI falls below 50, the economy will soon fall into a contraction. We already know the fact that XLI will underperform in an economic recession. Since these leading economic indicators are showing signs of a possible recession, we do not think this ETF is the best place to park your money at the moment.

Valuation Analysis

XLI’s portfolio of stocks has an average forward P/E ratio of 16.98x. This is slightly below S&P 500 Index’s 17.8x. Its average price to cash flow ratio of 9.22x is also 1 multiple below S&P 500 Index’s 10.18x. We think XLI is slightly undervalued on a relative basis.

Source: Morningstar, Created by author

Investor Takeaway

If you believe that an economic recession is still not imminent, there may be a short rally in XLI’s fund price in the second half of 2019 as we expect Boeing’s share price will rebound. However, if you think a recession is not too far away (e.g. end of the year or 2020), we think this small rally in H2 2019 may offer a good opportunity to reduce your exposure. For other investors with a long-term investment horizon, we recommend to wait till the beginning of the next economic cycle to invest.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.