Materials Sector (XLB) May See Sharp Contraction if Recession Strikes

June 15, 2012 10:50 AM EDT
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Materials have underperformed the broader market this year, with the most popular ETF Materials Select Sector SPDR (NYSE: XLB) lower by 0.32 percent compared to SPDR S&P 500 (NYSE: SPY), which is higher by 4.7 percent over the same period.

XLB performance was affected by the performance of its largest industry weighting, chemicals. Chemicals account for 66 percent of XLB's allocation, and its top holding is DuPont (NYSE: DD).

When evaluating the chemicals sector, it is probably worth taking a look at the recession of 2008, especially considering the recent slew of negative data in the US. According to Laurence Alexander of Jefferies research, there is an important lesson to learn with regard to valuation multiples for these stocks.

The chemical sector P/E was 15.3x in May 2008, while the S&P multiple was 16.0x. During the recession it contracted to 9.0x in December 2008 compared to the S&P at 12.0x. The current P/E for chemicals is 15.5x vs. the S&P of 13.2x, so there is clearly downside risk if the economy darkens in the U.S.

A recession in the U.S. is not a guarantee, but the odds are at least 10 percent, thinks Jefferies. In Alexander’s view, the current U.S. data supports a neutral weight on the sector, with a bias towards buying dips this summer ahead of a Q3 rally. But this view can change quickly if the U.S. dips in recession.

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