XLC: Communication Services Getting Stronger Despite Alphabet's Fall

Communication Services Select Sector SPDR® Fund ETF (NYSEARCA:XLC) entered correction territory after falling 10% from its recent mid-July high. The sell-off in XLC’s price is attributed to the broader stock market correction and Alphabet’s plunge. However, the dip presents an attractive buying opportunity because recent results demonstrate that the communication services sector’s growth trends are improving quarter over quarter. Moreover, the consumer and business spending environment also remains robust despite the Fed’s tightening. Besides disappointment on the cloud, Alphabet’s results were also strong. This is an update to my recent article, in which I provided buy ratings to XLC.

It is Correction, Not a Bear Market

The US stock market has had a bumpy ride over the last three months due to the Fed’s hawkish stance. Alphabet’s plunge added to investors' concerns and triggered a fear wave, resulting in sharp volatility in the stock market indices. Consequently, the broader market index, NASDAQ, and XLC have entered correction territory. A market correction, a drop of 10% from a recent high, often creates buying opportunities because stocks mostly bounce back and form a bull trend after corrections. Between 1974 and 2020, the S&P 500 entered into a bear market only 5 times out of the 24 corrections. Although several times these corrections turn into a bear market, I’m optimistic that the latest one won’t last longer and the market will bounce back in the coming months. There are a couple of reasons for the optimism, including robust economic and earnings growth trends. Despite pushing Fed rates to 5.5%, the US economy generated stellar economic growth in the past quarter.

In the third quarter, US GDP grew by 4.9% year over year, the fastest increase since the fourth quarter of 2021. In particular, consumer, business, and government spending was robust. Moreover, the US added 336,000 jobs in September, double the consensus estimate of 170,000 and up from 236,000 and 227,000 in August and July, respectively. Moreover, average hourly earnings soared 4.2% from a year ago, and the unemployment rate lingered in the range of 3.4 to 3.8% over the past few quarters. A strong job market indicates that consumer spending is likely to remain robust in the coming quarters, which is a key factor for corporate performance.

The earnings quality of S&P 500’s dominating sectors, such as information technology, consumer discretionary, and communication services, also mirror strong growth trends. Microsoft (MSFT), Meta (META), Amazon (AMZN), and others have exceeded expectations and raised their outlook. The S&P 500 earnings are expected to increase by 2.7% for the third quarter, reflecting the first quarterly earnings increase since the third quarter of 2022. FactSet data shows that mid-single-digit growth is expected for the S&P 500 in the final quarter of 2023 and high single-digit growth for 2024.

Therefore, with such a healthy economic and earnings growth, there are limited chances of correction to turn into a bear market. In fact, prospects are high that economic and earnings growth quality would help the market rebound and resume the uptrend that started in early 2023.

Communication Services Getting Stronger Despite Alphabet’s Fall

After a horrible 2022 in which the communication sector was the largest laggard in the S&P 500 both in terms of share price and earnings, the sector rebounded strongly in 2023, beating the S&P 500 both on earnings and share price. XLC, which offers coverage of the large-cap category of the communication services sector, appears well-positioned to extend gains. This is because XLC’s top 10 stock holdings, which account for 81% of its overall portfolio, have so far exceeded earnings estimates and most of them raised their 2023 outlook.

XLC’s share price plunge is attributed to Alphabet’s stock price fall, which accounts for around 22% of the overall portfolio. Alphabet’s stock price has lost around 9.50% of its value since it announced third-quarter results a few days ago. In my view, investors reacted harshly to its miss on cloud revenue, but they ignored the overall growth story. Its 11% year-over-year revenue increase in the third quarter was the best quarterly growth in the past five quarters, thanks to double-digit growth in its key revenue growth drivers, such as search and YouTube. Its search revenue surged 11% to $44 billion, accounting for more than half of the quarterly revenue. Moreover, its YouTube revenue of $7.95 billion soared by 12.5%, and Google's other revenue increased by 20.9% to $8.34 billion. Its cloud revenue also increased by 22.5% to $8.41 billion, but missed expectations. The company is expected to extend the cloud momentum, and it has been making amazing innovations across its entire cloud portfolio. In addition, the company has a significant amount of cash to invest in growth opportunities. In the third quarter, it delivered a free cash flow of $22.6 billion, bringing the trailing twelve-month free cash flow to $78 billion. Wall Street expects Alphabet to deliver double-digit revenue and high double-digit earnings growth in the following quarters.

Besides Alphabet, the latest results also highlighted the improvement in ad revenue for social media platforms. For instance, Meta Platforms, XLC's largest holding with a portfolio weight of 25%, significantly exceeded revenue, earnings, and user growth expectations. Its revenue of $34.15 billion increased 23% year over year, and operating income surged 143% to $13.75 billion. Furthermore, Wall Street expects Meta to post double-digit revenue and earnings growth in the following quarters.

Communication companies in the entertainment industry like Netflix (NFLX) have also surprised with a significant improvement in revenue, earnings, and subscriber growth. In the third quarter, Netflix's global paid subscriber additions of 8.76 million outperformed consensus for 6.2 million, up 10.8% year over year. Similarly, Comcast earned an adjusted earnings per share of $1.08 on revenue of $30.11 billion, compared to expectations for earnings of $0.95 per share on $29.71 billion in revenue.

In Conclusion

It’s time to follow Warren Buffett’s mantra of buying when others fear. The dip in price alone doesn't make XLC an attractive option, but the communication sector’s strong fundamentals back the potential upside in the medium and long term. Large caps in the communication services sector are witnessing robust revenue, earnings and cash flow growth, which I believe will be a key driver of the share price rebound. XLC’s low expense ratio of 0.10% and average share trading volume of 6.14 million also make it a great option for long-term investing.