The Consumer Discretionary Select Sector SPDR ETF (NYSE: XLY) has staged a remarkable surge higher in the quarter as the year draws to a close. The ETF rocketed 26% on the quarter to bring its YTD performance to 30% as of last week’s close. To put that into context, that performance has led even the growth and allure of tech giants, with the Invesco QQQ ETF (NASDAQ: QQQ), the popular tech-focused ETF, surging almost 16% on the quarter and up 28% YTD. 

A potential risk emerges as the XLY ETF surges to new highs, significantly outperforming the broader market. This raises the question: Is the sector now overbought and primed for a pullback or correction? One key metric to gauge such conditions is the Relative Strength Index (RSI). At its current level of 80.23, the XLY ETF is firmly in overbought territory, signaling heightened susceptibility to a short-term pullback. However, it’s equally crucial to examine how the sector's top players perform and to analyze specific data points influencing consumer confidence and spending, as these factors can provide deeper insights into the sector’s resilience or potential vulnerabilities.

Combination of Factors Have Boosted the Sector this Quarter

Consumer discretionary stocks have surged impressively over the past quarter, driven by resilient consumer spending and growing economic optimism, including optimism surrounding deregulation from incoming President-elect Donald Trump. 

Robust job growth and a resilient labor market have continued to fuel consumer discretionary spending. November’s nonfarm payrolls surged by 227,000, far exceeding expectations and rebounding sharply from October’s hurricane-impacted 36,000. Wage growth advanced 0.4% for the month and 4% annually, slightly outpacing forecasts and keeping consumer wallets strong. 

Despite a rise in the unemployment rate to 4.2%, signaling a potential easing in labor market conditions, the strong November jobs report has reinforced optimism about the economy's health. Signs of a soft landing, alongside expectations of another Federal Reserve rate cut this month, have eased recession fears and supported consumer confidence. Meanwhile, strong earnings reports from luxury goods, travel, and e-commerce companies highlight sustained demand, particularly from higher-income households and international markets. 

Adding to this momentum are projections for a robust holiday shopping season, buoying investor sentiment and driving a rotation into growth-oriented sectors like consumer discretionary, making it a standout performer in the year's final quarter.

Top 2 Names in the Sector Show No Signs of Slowing Down

The two largest holdings of the XLY ETF, Amazon.com and Tesla, collectively account for nearly 40% of the fund's weighting, making their performance critical to the ETF's overall direction and momentum. Given their outsized influence, these stocks are key considerations for investors debating whether to lock in profits or stay invested.

Amazon.com (NASDAQ: AMZN), the ETF’s top holding with a 22.22% weighting, has been one of the strongest performers in the consumer discretionary sector this year. AMZN recently hit fresh 52-week highs, pushing its YTD gain to nearly 50%. Analysts remain optimistic, projecting an additional 4% upside for the stock. The breakout to new heights underscores Amazon’s continued momentum, which bodes well for the stock itself and the broader sector.

Tesla (NASDAQ: TSLA), the second-largest holding with a 17.05% weighting, has staged a remarkable rally, becoming one of the top-performing stocks in the ETF. After a sluggish start to the year, TSLA rebounded dramatically following a strong Q3 report, improved sentiment, and innovations tied to its business model. The stock is now up 56% YTD, 35% for the month, and nearly 80% for the quarter. Tesla is closing in on its all-time high, near $414, and with strong upward momentum, it remains a powerful tailwind for the sector.

However, the ETF’s heavy concentration in these two names presents risks. Should AMZN or TSLA experience a pullback, the ETF could be vulnerable to downside pressure. While the current data and price action suggest further upside, investors should remain cautious, mainly as XLY trades at overbought levels based on its RSI. A reversal in either stock’s trend could warrant taking profits and reducing exposure to the sector.