Is the U.S. Consumer Really Dead?

2008 was certainly no joy ride for investors but 2009 could well turn out to be a walk in the park if the turnaround in the Consumer Discretionary sector is any indication. One ETF dedicated to this sector is the Powershares PEJ, a medium sized blended fund (it contains a mixture of growth and value stocks) designed to track the Dynamic Leisure & Entertainment Intellidex, an index composed of thirty stocks culled from the restaurant, gaming, leisure, and media industries. The three and a half year old fund hit an all-time low of $6.15 on November 21st, off 68% from its July 2007 high near $19.50.

A bullish chart

The November low formed the head in an inverse head-and-shoulders pattern as shown in the stock's daily chart below. The left shoulder formed during October, the head in November, and the right shoulder in December. The neckline was broken last Friday indicating that the stock is poised for a strong upwards move. Theoretically, one wants to see the neckline broken on heavy volume but last Friday's lackluster action can be forgiven since it was a holiday-shortened trading day with many people on vacation. Monday's action, however, more than made up for Friday's shortfall with the PEJ trading over twenty times normal volume! (Average daily volume is only around 9000 shares.)



Profit expectations

Once a stock convincingly breaks its right neckline, theory tells us that we can expect it to move to a value given by the neckline +/- (neckline – top of head). (+ for inverse formations; - for normal head-and-shoulders formations.) For PEJ, the neckline is at $9.40 and the top (or bottom, depending on your point of view) of the head is at $6.20 which means we should expect to see the stock rise to the $12.60 level. This represents a 28% increase over today's closing value of $9.85. Not a bad return! [Note: PEJ is not optionable, alas.]

Top 10 PEJ holdings

The table below shows the most recent top ten holdings for the PEJ. All together these stocks comprise almost 47% of the fund. From looking at the component charts, it's no wonder the fund has broken out. All of these stocks have been badly beaten down with the sole exception of McDonald's (MCD), which is nearing an all-time high.

If you're a DIYer and would rather concoct your own basket of stocks from this list, you may wish to start with Yum (YUM), Liberty Media, Brinker (EAT), and Ticketmaster (TKTM) which have all charged out of their recent black holes and broken out of their bases. Close on their heels are Marriott (MAR), McDonald's, Carnival (CCL), and Starbucks (SBUX). Pulling up the rear is International Gaming (IGT), which needs to break $15 before I'd be a buyer. Disney (DIS) is the only stock that seems to lack clear direction. It's been bouncing around the the low to mid-20s for several months and I'd prefer to see it break $26 (or better yet, $28) before stepping in. Based on previous price highs, this stock has less room to run translating into a lower potential return compared with the others.

[Note: The "Comment" column in the table represents the PEJ portfolio percentage.]

Summary

I'm not sure what a breakout in consumer discretionary means for the overall economy, but it suggests that fear in the financial markets could be unwinding and those stocks that have been brutally and perhaps unfairly discounted are being re-evaluated. Or, maybe it's just that folks are getting tired of all this fiscal belt-tightening and are looking to kick up their heels. I don't know, but whatever the reason, the charts are telling me that now is a good time to take a gamble on this sector.

Notes:

1. Liberty Media has three ticker symbols--LINTA, LMDIA, and LCAPA. I don't know the difference between them so I chose the one with the highest average daily volume.
2. PEJ currently pays an annual distribution (dividend) of just over 1%.

Comments

[Anthony Dad...:]

Consumer is not dead. Wounded but not dead. There are many that still have good savings and good incomes. Yes, credit is a problem, but all the initiatives will slowly lead to a thawing of the freeze and we will soon see money flowing again.

I am a contributor on thecreatingwealthblog....

Jan 06 08:10 AM

[nmelendez:]

The problem is not the consumer, it's the banks. They went on a derivatives binge based on 20% YoY growth. I know i am doing OK, took all my stocks and cashed out at S&P 1300. Now i am in treasuries and will protect the money until this blows over. If something drops 10% get rid of it. Thats why i switched.

Jan 06 08:55 AM

[Chris B:]

That "head and shoulders" looks like something else to me!

Does anyone really think that these ultra-consumer discretionary companies will actually increase earnings in an environment of 9% unemployment, stagnant wages, massive and unprecedented consumer debt levels, and a consumer savings rate that is reverting to the long term mean of 10% (from the current 2%) at the expense of consumption? Is this supposed to happen because of some perceived pattern in historical prices?

Are consumers who are looking at decimated 401k's, thousands in credit card debt, falling home values, and looming layoffs going to just take a Carnival cruise, sip a $6 Starbucks mocha, and buy yet another $15 Disney DVD to make themselves feel better about poverty?

I fully support buying compelling companies at the peak of pessimism, but I'm afraid that the industries represented in PEJ are going to face losses and consolidation for years. The systematic forces constraining consumers (debt, no savings, threat of unemployment, graying demographics, rising healthcare and energy costs) are going to be in place for years. No chart zig zag can change that.

Jan 06 09:44 AM

[CautiousInv...:]

The US consumer has been the foundation for our economy and the growth of many foreign economies. Supporting this spending habit has been mortgage equity withdrawals and balooning credit card and installment debt.

Now envision a scenario in which unemployment increases to 9% to 10% and credit is curtailed and/or reduced. It is exactly this we are in the midst of and it will be some time before the consumer regains his footing.

Jan 06 10:35 AM

[commoinsens...:]

This etf is very misleading. sure Macdonalds and kfc (YUM) are in some ways counter cyclical when the purse strings of middle america are tight. but Disney is hard to read because the theme park business is in the tank and will be for some time. This etf is in no way an indicator of where discretionary spending is heading.

Jan 06 11:40 AM

[commoinsens...:]

Sorry, on more comment. whenever some ends an article with "it may be a good time to take a gamble.." that's exactly what it is.... a gamble. and in most cases the house odds are not in your favor

Jan 06 11:43 AM

[Smarty_Pants:]

Chris B and CautiousInvestor:

What you say is true, consumers will be retrenching for quite a long time and this will impact earnings in this sector for the forseeable future. But there's more than one way to skin a cat in the market.

For as long as humans have had financial markets people have been making money by a number of different approaches. Doc is obviously a trader, looking to make a good return in a short timeframe with as little risk as possible.

"Zig-zags" on a chart are nothing more than an historical record of past prices, which themselves represent the perceived values of those who actually made the trades. Again, history has shown that there is a statistically favorable opportunity here in the short term.

Somebody is buying these stocks at higher prices since the chart bottomed. Who knows why? Who cares? For the short term, the perception of market participants is favorable in this sector as the rising prices demonstrate.

That doesn't mean a rally to all time highs is imminent, but it doesn't rule out the possibility either. Doc is merely pointing out that this is a chance to take advantage of the current perceptions which are driving people to buy.

She has given a reasonable target to exit the trade. Essentially she is saying that she's willing to bet some amount of money that the price will go up in the near term because she thinks the odds are sufficiently in her favor.

If she believes her mathematical expectation is sufficiently positive, then it's a good trading opportunity and worth pursuing provided you keep an eye on it to limit losses if the trade sours.

It's just a different approach to profiting in the markets. Believe it or not, Van K. Tharp has shown in his book that you can make profits with random trading signals if your money controls are good. He did an extensive test across many markets with a very simple trading system and it actually made money by randomly going long or short (50/50) every time his exit stop was triggered.

See "Trading your way to Financial Freedom" for details. It's an excellent book to read if you trade the markets.

Doc is simply using 'zig zags' as a way to improve her odds on the trade from 50/50 to something better, like 70/30. If you make a bazillion small trades with 70/30 odds of profit you will net 0.4 bazillion winning trades over the long term and profit, even if this trade loses money.

You will come out ahead as long as you don't bet so much that you go broke on any one trade.

Jan 06 11:59 AM