As earnings season begins to end, we’re feeling a bit mixed. According to FactSet, of the 436 companies that have reported Q2 earnings YTD, 73% have reported earnings above estimates and 51% have reported sales above estimates. Average guidance, however, has been worrying, along with the energy sector, which in several cases fared far worse than expected. Importantly, the percentage of companies reported above-estimate sales is below the 5-year FactSet average, further suggesting growth may be a higher concern than investors had thought. With this foundation coupled with a pending rate hike, we think there’s little to no upside for the markets in the near term. Consumer discretionary stocks, however, paint another story. Here’s why we think this continues to be an attractive sector for 2015:
The Fundamentals: The consumer discretionary sector is the 2nd best performer YTD, up 8.3% – far higher than the S&P 500’s 0.9%, and only slightly behind the leader, healthcare, up 9.8%. The forward P/E for the sector is at 19.5x, compared to the 15-year average of 18.2x, according to JP Morgan data. Although this may signal a slight expensiveness, we think earnings growth potential is much higher for the rest of the year compared to conservative estimates, for reasons mentioned below. More importantly, the P/E comparison concept, as a whole, has been distorted due to the low interest rates we’ve found ourselves in during this bull market; the equity asset class really has no alternative – and the ‘expensiveness’ of this sector is nothing extraordinary compared to the broader market’s forward P/E of 16.6x over the 15-year average of 15.8x. Furthermore, as rate hikes come nearer, we think the rotation of investors out of higher dividend-yielding sectors into this one will occur, given that the consumer discretionary dividend yield is the lowest (at 1.5%) out of any sectors in the S&P 500. We remain of the opinion that stocks are bound to take a breather when rate hikes come to fruition – this sector, meanwhile, might be a beneficiary.
A Robust Labor Market: July’s jobs report was yet another sign of a robust US labor market, with 215,000 jobs being added. YTD, the growth in nonfarm payrolls has averaged 208,000 a month – above the 5 year average of 190,000, suggesting that job gains are joining the party late, but at a great time to give a prop up to a bull market running out of steam. Inflation, as well as hourly wages have also been creeping up – slower than investors would like, but at least in the right direction. As we’ve highlighted earlier, small businesses make up over 75% of the US labor force, and utilizing small caps as a proxy, over 80% of their revenue is domestic, according to the Bank Of America. As is, exports form only 14% of US GDP. The bottomline? A strong US jobs market will help drive consumption, and considering consumption forms over 68.4% of US GDP (JP Morgan data), we think consumer discretionary stocks should be the rightful beneficiaries of returns.
Cheap commodities spurring consumer strength: Oil prices have been sliding, last settling at 43.87$/barrel for WTI crude, nearly reaching six-year lows set in March. Per our column on July 26th, we don’t see a major reversal for the trend – the ‘lower for longer’ phenomenon is aided by the strong dollar, oversupply, and an attempt by emerging economies (including China) to divert attention away from infrastructure-related growth, due to evident bubble signs amid weak demand. With oil prices down over 31% YoY, US consumers have benefited massively as a result, and they’ve used the money to pay off loans; debt payments as a percent of disposable personal income is at 9.9% (per JP Morgan data), a rate lower than that seen in over 25 years. As a result, via a clean balance sheet, consumers are well-placed to spend, and considering the personal savings rate dropped from 5.2% to 4.8% last month, this may be starting to get occur. Another data point worth highlighting? According to Federal Highway Administration data, stated by the WSJ, through May, travel on all roads had increased 3.4% over the same span from 2014 – higher by 2.3% compared to the previous record set in 2007. Annualized car sales in July, at 17.6 million, only slightly trailed June’s, which were a 10-year high. All in all, oil prices have benefited the consumer, and the gains are slowly beginning to show.
Sector Specifics: Economic indicators continue to show tailwinds for consumer discretionary; new home sales are up 25%, consumer confidence is up 21%, and household net worth is up 5% YoY, according to Fidelity data. The laggards within the sector have included the auto industry, homebuilding, and household appliances, while quicker consumption firms including internet retail, hotels, and restaurants have pulled the sector ahead. We think the latter group has room to catch up; Masco’s strong results over the last quarter, along with consumers locking in low rates and purchasing homes before rate hikes, all signal that durable goods firms should do better as the year goes on. It’s worth remembering, of course, that large durables firms have significant exposure abroad, and currency moves significantly hurt them in the first half of the year – but as a result, that’s already factored in to the stock prices. As is, according to Yardeni Research, the forward P/Es for homebuilding and household appliances are 13.4 and 12.7 respectively – very attractive ratios. Importantly, seismic changes in the way companies approach consumers is defining trends today; Google’s Nest, iRobot, Uber, among other firms, are all focusing on dissecting behavior, rather than spending. We think there’s a ton of efficiency to be derived regarding consumption. The FANG leaderboard (Facebook, Apple, Netflix and Google) have all led efficiency through technology, and there’s no reason why consumer discretionary firms can’t start doing this; those that have done so (Amazon, for example) – have shown significant upside. The bottomline? The stage is set to deliver, and we think spending tailwinds should help a sector that is ripe for disruption by focusing on consumer behavior.
What it means for you: As the Dow Jones Industrial Average continues to trail the S&P 500 and Nasdaq in YTD returns, it is a telling sign that bigger is not always better in today’s economy. With pending rate hikes and quantitative easing abroad, the strong dollar isn’t racing off anywhere soon. It makes sense to focus on the US consumer, given the domestic economy continues to show an extremely strong foundation. The consumer discretionary sector is one where growth is driven by consumption – and that’s a switch that can be turned on or off much easier than, say, manufacturing or infrastructure stocks. At a time when the markets are looking more and more directionless, it’s worth looking at the consumer to provide some momentum to Wall Street in the coming weeks.
