Consumer Discretionary Stocks: Predicting an Upturn, but Don't Bet on a Recovery

Feast or famine, apparently, is how investors perceive and process economic information. As 2009 began, I was extremely bearish on the economy and pretty bearish on stocks, yet I held a high percentage of Consumer Discretionary stocks due to my belief that they were severely mispriced, especially small-caps. You may recall an article that I contributed on the subject in late October or the follow-up a month later, where I shared more than a dozen retailers trading below book value. While the performance of these stocks has been mixed but better in aggregate than the market, several of the companies have more than doubled in value. Using the same criteria, only 5 stocks make the list today.

Looking at performance by sector year-to-date, I note that the S&P 500 Consumer Discretionary stocks are up over 6%, which is 10% better than the overall market. This is quite impressive, especially considering the almost 4% superior performance in 2008. Looking at small-caps (the S&P 600), where the Consumer Discretionary stocks lagged the index by about 11% in 2008, the YTD return is a stunning 17% (more than 22% ahead of the index). Talk about a snap-back!

What's going on? Why are Consumer Discretionary stocks doing so well, and, more importantly, will they continue to do so? I believe that there are several reasons for the strong performance:

• Too much pessimism priced into the stocks in Q4-08 (and even in early March)
• Recognition that the balance sheets are overall very strong compared to other sectors
• Benefits from the strong $
• It's in the playbook
• Piling on

In addition to many stocks trading at or near book value (which is just a metric), the stocks were very oversold. As a matter of fact, they were probably the most oversold that they have been since that time period everyone likes to talk about but for which we don't exactly have comparable data. The large-cap Consumer Discretionary stocks actually trade as an ETF: SPDR Consumer Discretionary (XLY). The StockVal price momentum index for the ETF bottomed in Q4 at -5 and then a more traditional extremely oversold level of -3 in March. This number represents the number of standard deviations from the 20-week moving average based upon the volatility of the security over the entire time period. Typically +/- 2 captures most scenarios. As you can see (click to enlarge), this was a lot worse than after 9/11:

While there is no ETF for the small-cap consumer discretionary stocks, I assure you the chart above would be even more extreme to the downside and to the upside. Below (click to enlarge) is the price chart for the last 10 years and an interesting tell that the market gave in March. Notice the divergence, with the price making a new low (but not as "oversold" as we could see in the chart above), while it actually was outperforming traditionally more econmically insensitive Consumer Staples:

Not only did we diverge, with Consumer Staples way underpeforming Consumer Discretionary from the November lows to the March lows, but look at how much the relative underperformance from 2007 and 2008 has now retraced (more than 1/3). I believe that what happened addresses my 2nd and 3rd points above (balance sheets and dollar sensitivity).

When I wrote in late December about how important it would be in 2009 to pay attention to the balance sheet, I noted that the Consumer Discretionary sector, while not one of the top areas (Tech, Health and Energy), was better than average. This is certainly the case in smaller names in the sector, as many of the components of the S&P 500 are heavily leveraged companies like hotels, cruise ships, automobile manufacturers, etc. The median net debt to capital for the sector is 32% in the S&P 500 but just 22% for the S&P 600. In any event, some of the relative strength of the sector is most likely related to a growing appreciation of the better than average balance sheets. While not all of the larger names (>$10 billion market cap) that are performing the best have the best balance sheets of the group, it is interesting to note that most do (Amazon (AMZN), Best Buy (BBY), TJX (TJX) and Kohl's (KSS), while some of the larger names that are performing the worst have below-average balance sheets (Time Warner (TWX), Comcast (CMCSA) and McDonald's (MCD).

Another big change since the year began has been the value of the dollar, with the Euro depreciating by 9% and the Yen by 8%. In aggregate, the Consumer Discretionary sector has quite different exposure to currency changes than Industrials. Many of the names, especially in small-cap, tend to be primarily oriented towards the domestic market and also tend to be importers. Thus, the strengthening dollar may actually be advantageous. Consumer Staples and Industrials tend to export a lot, so it isn't surprising to see them underperforming Consumer Discretionary, though the reasons certainly include the balance sheet issues discussed above.

My final suggestions for what's going on is what I referred to as "the playbook" and "piling on". For those not familiar with what I am calling the playbook, historically stocks that are "early cycle", like clothing, restaurants, and other consumer-oriented stocks recover from recessions first, while "late cycle" stocks like airplane manufacturers follow later. So, many are apparently betting that the trillions of dollars of stimulus, loan guarantees and capital infusions will right the economy, and they want to be positioned for "pent up demand". The only problem with their thinking in my opinion is that they underestimate how dependent the economy has been on consumer credit. I will grant them the pent-up demand aspect, as consumers would certainly like to reengage in consuming at will, but this time is truly different. Until the financial system returns to some sense of normalcy, "able" to spend trumps "ready and willing" to spend!

Professional investors in general have put themselves in a very bad situation, becoming too bearish on stocks and having way too much cash. Stocks were pretty much a one-way street in 2008, especially at the end, and into 2009, but the imbalances have been or are being corrected now. The typical long-only professional investor that I talk to has been furiously reinvesting. After enduring definitely horrible absolute performance for the past 6 quarters and most likely not-so-great relative performance, the pros can hardly afford to miss the rally. The long-only investors are positively biased in any event. After all, who can go to work in the morning at a place only able to buy stocks when they don't think stocks are likely to rise in the future? While I have no evidence of this, I can imagine the thought process:

Holy crap, I thought the world was coming to an end, and I had as much cash as I could possibly have. Our assets under management are already down 50% over the past year as stocks have plunged and investors have withdrawn. If this keeps up, I will have to look for a real job! Now the market is flying. This makes no sense. I better grab some cyclicals. They are already going up, so the recession must be almost over. Why didn't I see this coming?

The point I am trying to make is that the folks playing by the book are most likely sucking in these poor whip-sawed folks with their piles of cash built up as the market plunged. These people want to believe that the bear market is over, so it doesn't take a lot to convince them! It's very early in the year - no one wants to "get behind". Thus, it becomes very convenient to interpret what could be noise as a predictor. Yes, the Consumer Discretionary stocks are predicting an upturn, but they could be wrong! I think that they are wrong and have acted accordingly, perhaps too early. While I had a very high exposure to Consumer Discretionary stocks at the beginning of the year, I have none presently, though I have a slightly-below-market bid for one that just slashed its earnings outlook and actually fell (how strange these days!). I have turned my portfolio over into one that looks like it is designed for little old ladies. As always, I disclose daily my holdings, and you are free to see what I am talking about.

For those who follow my thinking that I convey on a very regular basis on Seeking Alpha, you know that I have a thought process that revolves a lot around regularly reviewing screens that I have set up. While I have had to create a lot of new screens over the past year as I have come to realize that we are in a new environment, I still check in with the old ones. The new screens have more inputs like "extremely oversold", "below tangible book value" or "no net debt", while the older ones relied on price momentum, earnings or sales based valuations, positive estimate revisions, etc. The sad fact is that some of these old screens were drawing complete blanks. A very successful screen that I created early in 2008 was designed to identify shorts, and it had become totally unproductive until very recently (finally SOMETHING is showing up - Wal-Mart (WMT)). One of my old screens, which I created to find extremely overbought stocks (so that I could sell them if I was fortunate enough to own them or to possibly short them otherwise), was turning up blanks not surprisingly from October through early March, but it is now loaded with names despite the many inputs I use to restrict the list (minimum price of 10, minimum market cap of $500mm, minimum 50% move off the 52-week low, maximum EPS revision of 20% over the past 12 weeks). In any event, the current screen has 178 names that are "extremely overbought". A disproportionate 83 are from the Consumer Discretionary sector.

To illustrate what I believe are unsustainable valuations, I am adapting my usual screen. Here is what I did:

• Universe: Russell 3000 (which reduced that previous 83 by 1)
• No minimum price or market cap (now we are up to 148 out 436 in the index!)
• Price momentum index minimum of 3 (instead of 1.8, which gets it down to 53)

You can download the list of EXTREMELY overbought names: Download Overbought Consumer Discretionary

Here are some general observations:

• Median YTD price return of 50%
• Typical earnings estimates have declined 10% over past 12 weeks
• Median price to 52-week low of 3.4X
• Median of 3.67 standard deviations from long-term moving average
• 1/2 the list is expected to lose money over the next year
• Typically, these stocks have challenged balance sheets

So, we can see that in general Consumer Discretionary stocks have exploded. The list above, which represents the extreme, indicates a major revaluation has taken place. As I have advised my clients and the subscribers to my model portfolios, this isn't a time to be betting on a recovery. Don't be fooled into believing that the prediction being offered by consumer stocks is accurate, as we are likely to see very little growth in the economy over the next 18 months. This massive move, a bear market rally, is simply correcting what was too much pessimism earlier this year. To put things in context, it was mathematically impossible for the economy to continue to decline at the sequential rate of late 2008 and 2009. The fact that it is stabilizing shouldn't surprise anyone, but there is very little evidence of potential growth in any part of the economy absent government spending. The real clue regarding the timing of economic recovery will come from the bond market, not the stock market. Hope springs eternal, but, as the chart below shows (click to enlarge), it is misguided:

While there has been some improvement, spreads remain at unprecedented levels. Have they peaked? Perhaps and hopefully, but I expect a long plateau. I note that in the last bull market, which began in March 2003, Baa spreads and high-yield spreads, which peaked concurrently with the bottom of stocks in October of 2002, had already returned to flat levels from a year ago when that bull market began. We don't have a lot of data points to work with here, but I would expect that an economic situation as dire as this one will still follow what seems to be the norm: The bull market begins after a return of spreads to more normal levels. For the past 10 years, the median Baa spread to the 10yr Treasury has been 2.3%. Typically, 150 bps has been low, while 400 bps has been high. The current level in excess of 500 bps is still OFF THE CHARTS. While I don't think we need to see that spread return to the median to call off the dogs, I surely would like to see it come back into the range for the prior 45 years!

So, here is what I am doing: Raising cash to the extent possible, paring companies with iffy balance sheets, paying attention to how far the stocks are from tangible book value, and moving to less economically sensitive industries. This is a great opportunity to rid our portfolios of companies that depend upon discretionary spending by consumers. The pendulum had swung too far in one direction, and now it has swung too far in the opposite way.

Disclosure: No position in any stock mentioned.

Comments

[Steven Hansen:]

alan, this is the kind of analysis which makes seeking alpha great - whether you agree or not with its conclusions.

Apr 26 12:42 AM

[Alan Brochs...:]

Thanks for your kind words, Steven...


On Apr 26 12:42 AM Steven Hansen wrote:

> alan, this is the kind of analysis which makes seeking alpha great
> - whether you agree or not with its conclusions.

Apr 26 06:08 AM