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Discretion Advised: Consumer Discretionary Valuation Soars

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The Consumer Discretionary sector has outperformed the market by more than 5 percent this year, and it has now become the sector with the highest price-to-earnings ratio in the S&P 500. So is it time for investors to exercise some discretion of their own—and take profits?

FactSet reports that the Consumer Discretionary sector finished May with a forward 12-month price-to-earnings ratio of 16.9. That makes it the sector for which investors are willing to pay the most for the expected earnings over the next 12 months.

Consumer Discretionary takes the mantle of highest-valued sector from Telecom Services, which enjoyed a 18.2 P/E at the end of April. But in what could be considered a bad omen, the Telecom Sector suffered a 7.4 percent drop over the month of May, while Consumer Discretionary stocks rose by 2.4 percent.

"As a result, the forward 12-month P/E ratio for the Consumer Discretionary sector jumped to 16.9 from 16.7 last month, while the forward 12-month P/E ratio for the Telecom Services sector dropped to 16.6 from 18.2 over this time frame," FactSet senior earnings analyst John Butters wrote in a Friday note.

In other words, it was almost entirely the price decline of the market's highest-valued sector that led this dubious title to change hands during the month of May.

According to Carter Worth, chief market technician at Oppenheimer, the good times for Consumer Discretionary simply cannot last. "As a sector, Consumer Discretionary is steep and uncorrected," Worth wrote to CNBC.com, "and judged likely to encounter the same profit taking/short selling that is affecting other sectors of late."

But Mike Khouw of Dash Financial says it isn't quite that simple.

When it comes to the P/E valuation, "Part of what's throwing off that number are stocks whose valuation are sheer stupidity. That's Amazon, Netflix and the like" said Khouw, who is an "Options Action" contributor.

Indeed, popular highflyers top the list of the sector's highest-valued stocks based on expected earnings. Amazon enjoys a forward price-to-earnings ratio of 133, while Netflix is right behind it with 101. Rounding out the top 10 are hot names like Chipotle, Starbucks and TripAdvisor.

After we strip out the stocks with the highest valuations, "what's left probably deserves to trade at a higher multiple than, for example, the staple stocks," Khouw said. "We're finally getting to a point where names that represent some growth potential are finally being prices to reflect that."

Khouw believes that in an economy with low interest rates and increasing consumer confidence, "those higher valuations are probably appropriate."

In fact, a look at history shows that the sector's valuation has been much higher in the past. "The last time the Consumer Discretionary sector had the highest month-end, forward 12-month P/E ratio was May 2009," Butters told CNBC. The sector's forward P/E then was 29.0, making the current 16.9 look downright de minimis.

—By CNBC's Alex Rosenberg. Follow him on Twitter @CNBCAlex.

Follow the show on Twitter: @CNBCOptions.

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