Even though it is the only Vanguard sector ETF to decline in 2024, I have high hopes for this fund over the next 5 years

Studying the sectors of the stock market can tell us a lot about what is driving the broader indices up or holding them back. And if you’re more focused on individual actions, it can give you clues as to where to look.

A prime example today is the consumer discretionary sector. Consumer discretionary is the only one of the market’s 11 sectors to decline this year, but I think there are good reasons for long-term investors to expect a recovery. There are plenty of low-cost exchange-traded funds (ETFs) that mirror the composition of a particular sector and Vanguard Consumer Discretionary ETF (VCR 3.35%) is a great way to invest in it.

Here’s why the consumer discretionary sector is underperforming the broader indexes and how to use ETFs to achieve stock market diversification.

Image source: Getty Images.

Not your typical ETF

Discretionary consumption covers a wide variety of consumer-focused industries, such as retail, automotive, home improvement, restaurants, resorts, and cruise lines. These are the things most consumers buy after covering their basic needs, such as food and personal care products (which fall under consumer staples).

It is a unique sector for several reasons. If you take a look at the holdings of the Vanguard Consumer Discretionary ETF, what immediately stands out is the 23.4% weight in Amazon (AMZN 4.40%) and the share of 10.6% in adze (TSLA 6.34%).

Amazon is in this sector because of its focus on e-commerce and retail. But it’s no secret that Amazon Web Services is arguably the most valuable aspect of Amazon today. The company would likely fit better in the technology sector given its focus on cloud infrastructure.

Tesla is in a similar boat. Tesla is focusing less and less on electric vehicles and more on robotics and artificial intelligence. And even Tesla CEO Elon Musk has told investors that if they don’t believe in widespread adoption of the company’s Full Self Driving technology, then they shouldn’t own the stock. So there is also a case where Tesla could be in the technology sector.

Here is a full description of the industries covered by the Vanguard Consumer Discretionary ETF:

Data source: Vanguard.

Other sectors may be highly concentrated in just a few industries. For example, the technology sector is essentially divided into hardware and software. Financing mostly includes large banks, regional banks, credit card companies, insurance companies and asset management companies. So the diversification of the consumer discretionary sector into so many industries is a unique feature.

However, many of these industries can be highly correlated with the wider economy.

Consumer spending does not drive economic growth

The consumer discretionary sector has not participated in the broader stock market rally for a painfully simple reason — economic growth is driven by corporate spending, not consumer spending.

VPU data by YCharts

Big tech companies are investing billions of dollars in Nvidia chips. Increasing energy demand to support economic growth and the computing power needed to run complex artificial intelligence models could benefit pipeline and energy infrastructure companies and utilities.

Consumers are less likely to cut spending on household goods produced by Procter & Gamble (PG -0.52%) or beverage brands owned by Coca cola (K.O 0.10%) the same way they would delay a large purchase such as a new car or house. And of course P&G and Coca-Cola are both around all-time highs.

It’s hard to know exactly when consumer spending will pick up again. But there are some useful economic indicators that provide clues to consumer health.

US Credit Card Debt Data from YCharts

As you can see in the chart, US credit card debt initially fell during the worst of the COVID-19 pandemic, but has since risen — indicating that consumers are buying goods and services they can’t afford.

Thirty-year mortgage rates have fallen from their highs near 8%, but are still high relative to 10-year averages.

The Case-Shiller Home Price Index is a benchmark for the cost of the average single-family home in the US. The index rose in 2020 and 2021 and has slowed its growth rate, but is still rising.

The US Housing Affordability Index — one of my favorite economic indicators — tracks the relative affordability of a 30-year mortgage, assuming a 20 percent down payment. A level above 100 indicates that the typical family can afford the monthly loan payment on a typical home. But a level below 100 indicates that this typical loan is not affordable.

Before the pandemic, it was around 150 — give or take. Today, it’s at just 93.3. High credit card debt coupled with relatively unaffordable housing has been bad news for the consumer discretionary sector.

Declining consumer spending affects everything from home improvement to vacation spending to high-end clothing spending (just ask Lululemonwhich is down 50% year to date). However, if the Federal Reserve eventually cuts interest rates, we could see consumer health improve over time.

Consumer discretionary stocks are a good value

It is important to understand the external factors that can influence the performance of a stock market sector or an individual company. For example, Home Depot (HD 1.24%) is a very well run, industry leading company. It can’t control the housing market or the health of the consumer, but it can take steps to maintain financial health and position the business to withstand downturns.

At a price-to-earnings ratio of 27.7, the Vanguard Consumer Discretionary ETF isn’t terribly expensive, given that the valuation is inflated by its heavy concentration in Amazon and Tesla. Strip out those companies and you’re looking at a P/E ratio of just 18.74 for the sector.

The sector is out of favor for all the right reasons and there are simply too many good companies at multi-year lows to be too pessimistic about the sector right now. I have high hopes for the consumer discretionary sector going forward, and the Vanguard Consumer Discretionary ETF provides a great starting point to dip your toes into the sector. However, the best approach may be to do some additional research and find the brands you have the most confidence in and invest in the individual stocks associated with the ETF.