XLI: Industrials Should Continue to Benefit From the Rotation Away from Tech

The tech-heavy NASDAQ composite as shown in the blue chart below has been losing ground since the first week of December, by -3.7% thereby negating some of its precedent episodic upsides. Now, the fact that the Dow Jones industrial gained 1.9% (purple chart) during the same time period shows that investors are rotating away from technology and returning to the more cyclical sectors of the economy like industrials.

Source: cnbc.com

Looking at the sector, after having delivered a 16.36% one-year gain, the Industrial Select Sector SPDR (XLI) finished the week ending Dec. 31 in the green +1.82%, while the SPDR S&P 500 Trust ETF (SPY) rose by +0.93% for the week and finished the year with a 27.04% gain. Therefore, the current momentum induced by the DJIA and a comparison with the broader market (S&P 500) shows that XLI or any other ETF with Industrials has the potential to produce further upside.

Hence, scanning the passive investment vehicle space, with an expense ratio of 0.12%, there are peers like the Vanguard Industrials ETF (VIS) and the Fidelity MSCI Industrials Index ETF (FIDU), whose fund managers charge less, or 0.10% and 0.08% respectively. However, the SPDR fund’s appeal at the current juncture is its higher dividend yields at 1.23% due to the U.S. Fed likely accelerating the pace at which it will hike interest rates.

In order to achieve such a yield, XLI tracks the Industrial Select Sector Index. This index seeks to provide an effective representation of the industrial sector of the S&P 500 index which signifies very large corporations while providing investors with exposure to the following industries: aerospace and defense; industrial conglomerates; marine; machinery and transportation infrastructure. Holdings also include road and rail, air freight and logistics plays as well as airlines.

Source: ssga.com

Looking deeper, some of the names like United Parcel Service (UPS), Union Pacific Corporation (UNP), Raytheon Technologies Corporation (RTX), and Honeywell Corp (HON) have their Price to Earnings ratios varying from 27x to 40x. This brings us to one of the rationales for owning an ETF, in contrast to highly-valued popular stocks. In this case, XLI bears lower valuations with a P/E of only 26.25.

Furthermore, these are XLI’s top four holdings, each with a market cap of over $100 billion. They have delivered gains ranging from 3.7% to 10.4% in the past month and this looks like to continue while tech takes a beating.

Pursuing on a cautionary note, the higher probability of faster-than-expected U.S. rate hikes and the Fed hawkish tone has also impacted the DJIA which dropped by 1.1% on Wednesday. Therefore, there may be other short-term pains and some may prefer to wait for the SPDR ETF to come slightly down from the $105-106 range, (which constitutes an all-time high), before investing in order to benefit from a better margin of safety.

Finally, with the macroeconomic backdrop remaining positive, the Omicron spread not resulting in more hospitalizations, and the recovery being well on track, XLI could rise to the $108-110 range by mid-2022 and in the worst-case scenario of an unexpected downturn, its mega-caps should prove useful to insulate investors against abrupt stock market fluctuations.