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By Joseph Hogue, CFA

The market has been volatile lately ahead of the possibility of a fiscal cliff-induced slowdown in the economy. Investors have been focused on business investment and let out a collective sigh of relief with the better-than-expected durable goods report this week. Friday may be a rude awakening though if recent trends in retail sales carry through to personal expenditures. Investors may want to position away from cyclically-volatile sectors like consumer discretionary or names within the space facing additional weakness. Companies with stronger fundamentals that pay a reasonable dividend should outperform as the market looks to safety.

Personal income and expenditures is released at 8:30am EST on Friday and holds the potential to send the market lower on a negative surprise. Income increased 0.4% in September after a 0.1% increase in August while spending rose 0.8% as consumers opened their wallets at the expense of savings. Demand for services increased by 0.4%, the largest since a 0.5% increase in April. Strength in last month's report belies a weaker trend in quarterly numbers with a declining rate of growth in expenditures.

Consumers tightening after several quarters of spending beyond their means

Retail sales in October fell for the first time in four months and may presage a drop in this month's expenditures data. Quarterly data from the Bureau of Economic Analysis shows a disturbing trend in personal income and expenditures over the last decade. The chart below compares annual growth in personal income and expenditures in each quarter since 2001. The chart shows the bipolar nature of U.S. shoppers, increasing spending at a faster pace than income for only so long then reversing the trend.

Personal Income and Expenditures
(Click to enlarge)

Shoppers are able to maintain a faster pace of spending by decreasing the amount they save as a percentage of disposable income, as shown in the chart below, but economic realities catch up sooner or later. With the savings rate already at a low 3.3% in September and growth in consumption falling for four straight quarters, Friday's report could show a continued trend to slower consumption.

Savings as a percentage of disposable income
(Click to enlarge)

Of course the underlying cause for much of the weakness is the sluggish nature of the recovery and a still high unemployment rate. Economic growth of 4% in the most recent recoveries was enough to reduce joblessness and lift income growth. Growth of 2% or less over the last year has not been enough to lower unemployment or to help increase earnings. Expectations for growth of just 1.5% in the fourth quarter and a return to 2% growth next year will not do much to help matters.

Unemployment and GDP growth
(Click to enlarge)

Consumer discretionary to feel the pain

Names in the consumer space will get hit disproportionately if expenditures drop unexpectedly. Shares of the Consumer Discretionary Select SPDR (XLY) have easily outperformed a 10.4% run in the S&P 500 with a 19.4% increase since January. The sector now trades for a relatively expensive 17 times trailing earnings against 14 times in the general market. This is on top of a dividend yield (1.44%) across the sector that is more than a half a percent below the 2% yield in the general market.

Beyond the general overvaluation in the sector, several names look particularly weak and could be due for a pullback.

Shares of Lions Gate Entertainment (LGF) have soared 93% this year on blockbusters like The Hunger Games and Twilight. Strength at the box office helped the company nearly double revenue in the quarter ending September 30th to $700 million, beating analyst estimates. Revenue going forward could be less impressive with Hunger Games 2 not scheduled until late 2013 and no other big releases scheduled for several quarters. Since 2008, the company has only managed annualized revenue growth of 3.9% and earnings just turned positive last quarter after four quarters of losses. While the shares trade for a seemingly cheap multiple of 14.4 times forward earnings, expectations may be lowered without a strong line-up in the theatres.

Electronic Arts (EA) beat expectations last quarter with $0.15 per share on a 38% increase in digital revenue while overall revenue fell 0.6% compared to the same period last year to $711 million. Management disappointed investors with a forecast for just $0.50 to $0.60 per share for the current quarter against expectations for $0.70 per share. The company is facing tougher competition from other firms as well as plummeting sales across the industry for console games. Retail sales of video game software, hardware and accessories fell 25% in October just as companies ramp up for the holiday season. Revenue has increased just 3.1% on an annualized basis since 2008 and the company's net margin of just 0.4% leaves little room for mistake.

Sprint Nextel (S) has jumped 141% this year on investor hopes that the company will eventually return to profitability. Strong smartphone sales are expected to result in a loss of just $0.79 next year versus a loss of $1.46 per share in fiscal 2012. While this would be a good start, the company is not expected to positive earnings until 2015. The company's return on equity is -40.0%, lower than 82% of peers in the industry, though its gross margin of 41.2% is about average for the industry.

Safety in deep value and dividends

If the tough macro-environment starts to detract from consumption, cyclicals and consumer stocks should underperform. Investors may want to position their portfolios in stocks that are less cyclical and have stronger fundamentals. Shares of Merck & Company (MRK) have gained 14.6% this year on strong pricing for branded drugs and demographic trends. The company has several strong drugs in the pipeline including V503, a vaccine for HPV-related cancers, and Tredaptive, an extended release cholesterol treatment. The company's return on equity of 12.2% is above 83% of peers in the industry. The shares trade for just 12.4 times forward earnings and pay a 3.8% dividend yield.

Whether we get a grand compromise or not on the fiscal cliff, the inevitable tightening by federal and state budgets next year will detract from the general economy and flow through to consumers. Fears of a cliff in Washington could bring this through to economic data much sooner than anyone expects. Consumers have already started to slow growth in expenditures and the unemployment rate does not look to aid income growth. Investors may want to watch important reports like Friday's personal income release and position for safety.

Source: 5 Stocks For The Coming Consumer Nightmare