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US penny-pinching is discounting these stocks

Shaky consumer confidence is creating havoc for exchange-traded funds tied to discretionary spending.

Consumer spending rose in May, but at a pace that trailed price inflation, and was particularly weak for a "pent up" spending period coming after the extreme winter weather. The latest Commerce Department report also showed that Americans continue to save more than they spend, even as personal income rises.

The consumer discretionary sector has rebounded a bit in June (up 1.9 percent), but it's the only sub-sector within the S&P 500 that has turned in a negative performance this year, as of June 27, according to an analysis done by Yardeni Research.

Still, bulls don't think the recent rebound in the American consumer bet is a fluky one.

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A 6.3 percent unemployment rate remains higher than where many policymakers would like, but the rate is as low as it's been in more than five years. Though the International Monetary Fund has slashed its growth forecast for the U.S. economy to 2 percent this year, that is still better than the 1.9 percent gain the economy registered last year.

"I continue to be bullish on the consumer going forward in the second half of the year and into 2015," said David Bettencourt of ETF Daily News, in an email. "Exceptionally low rates, low inflation and an uptick in jobs will fuel the consumer and the [consumer ETF] XLY. XLY also has a dividend which makes it attractive."

The SPDR Discretionary ETF (XLY), the SPDR S&P Retail ETF (XRT), and the Vanguard Consumer Discretionary ETF (VCR) have all posted declines this year even as the broader market indexes reached record highs. More specialized ETFs betting on consumer spending, such as the PowerShares Dynamic Media Portfolio (PBS) and PowerShares Dynamic Leisure & Entertainment fund (PEJ), have also turned in lackluster performance.

The approaches these ETFs take to targeting consumer spending is varied.

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XLY, for instance, has media companies including Walt Disney and Comcast in its top 10 holdings with Home Depot, McDonald's and Priceline.com. Vanguard's VCR also has significant exposure to media companies. The sector accounts for roughly 30 percent of both ETFs.

"Some of the media companies—it could be a push to say they are consumer discretionary companies. It's not right or wrong, but some could contest that," said Spencer Bogart, an analyst with ETF.com, though he added that XLY and VCR represent the sector well overall.

XLY is among the editors' picks at ETF.com and has a low 16 basis point expense ratio, among the lowest in the sector.

VCR, the Vanguard ETF, casts a wider net than its rival, holding many more stocks—385 to XLY's 84. VCR's expense ratio is 14 basis points.

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There are slight sector diversions among the two biggest consumer ETFs. VCR has a 17 percent weighting in hotel and entertainment stocks; XLY reports a 1 percent stake in software and IT service.

Both ETFs should do well if consumer confidence continues to slowly, but surely, improve.

That hasn't yet happened in anything resembling a straight line. Recent data released by Thomson Reuters/University of Michigan June sentiment index showed an increase to 82.5, up from a preliminary reading of 81.2 and a May reading of 81.9. That was better than expectations, but still below the April level and the year-ago reading.

"We are cautiously optimistic (about the future)," said Scott Hoyt, an economist at Moody's Economy.com. "The economy should be positioned to move forward more powerfully," in the second half of the year, he said.

Reasons to refine a consumer bet

Analysts like XRT, the retail stock-targeted ETF, because it is equal-weighted, meaning that stocks carry the same value in the index regardless of their market capitalizaton. This is important given that one of its stocks is Sears Holdings, billionaire Edward Lampert's struggling retail chain. Though the stock is down more than 20 percent this year, that doesn't hurt XRT shareholders nearly as much since the stock makes up about 1 percent of the firm's holdings. Another plus for XRT is that it holds many small-cap retail stocks, which tend to perform better in a rising stock market than larger-cap companies, Bogart said.

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PBS and PEJ have the highest expense ratios of the consumer ETFs, with expense ratios of 63 basis points. They make sense for investors who are looking to do a targeted bet on either media or leisure stocks but wouldn't be right for long-term, buy-and-hold investors because there are plenty of cheaper alternatives, Bogart said.

Bettencourt is a fan of PBS, because its holdings include Walt Disney, which is reaping the benefits of its $1 billion-plus hit "Frozen" and can take advantage of the mergers and acquisitions activitiy in the sector. Time Warner Cable may be acquired by Comcast, pending government approval, and AT&T plans to buy DirecTV . (Disclosure: Comcast is the owner of NBCUniversal, the parent company of CNBC and CNBC.com.)

Bettencourt is less of a fan of PEJ. Restaurant chains, including Chipotle and Sonic, account for more than 34 percent of its holdings and rising commodity prices are pinching the sector. Leisure and recreation companies, including Marriott, account for 23 percent; and Wynn Resorts and other casino operators account for about 12 percent. Casinos have been hurt by declines in business in Macao and rising competition for the U.S. gambler.

—By Jonathan Berr, Special to CNBC.com

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