No Reason to Expect Consumers to Keep Spending

Includes: FDO, FXD, FXG, PSL, VCR, XLY
by: Wall Street Strategies

By Brian Sozzi

Lost in the debt ceiling shuffle of the past month or so is the real standing of the U.S. consumer (not "what if" mortgage and credit card payments go higher via a debt default) at this pivot point in the year. With government spending on the chopping block and an export boom transitioning into export stabilization as emerging markets cool, to reach the falling, yet still optimistic, 2H GDP growth assumptions of economists much hinges on the appetite of the U.S. consumer to buy stuff. The appetite could either be for daily necessities or a gift that lifts the spirits of a person on a rainy day, but the fact is market mavens are wagering that the consumer emerges from the cocoon (the consumer can still move inside the cocoon, but the movement is hindered) that they have wrapped themselves in for a good part of 2011.

I am already laying eyes on pretty heady sales forecasts for the back to school season, though investors should be mindful that prices for products are materially higher than last year and that tough choices by the consumer on quantity will have to be made. Price points on final products are up for two basic reasons. First, retailers are about to drop another price bomb on consumers to earn back the inflationary costs that arrived earlier in the year, leaving the smartphone price checkers and Sunday coupons as the only lines of defense to saving a few dollars. Two, everything I have read lately from retailers suggests promotions will be very targeted and measured. A great example is Office Depot (NYSE:ODP), which is not experiencing an "irrational" industry discounting backdrop so has opted to invest its promotional dollars where there is the biggest bang for the buck.

The new age of investing is one in which near-term news of the day dominates the decision-making process and the future arrives after a million different external occurrences goes down. Putting the pieces to the investing puzzle together is next to impossible for the average Joe as the actual puzzle being built is forever changing. In the case of the consumer, to me the arrows point to a continuation of boom and bust periods in retail, where a sales trend up or down is missing in action. I think it's important to flesh out the macro thoughts behind such a view:

1. PCE (personal consumption expenditures) in 2Q rose a negligible 0.1% compared to a 2.1% gain in 1Q. As long as the savings rate stays above 5% as it has since August 2010, due to absent confidence on income and jobs prospects, and the near-term need to have a safety net to fund basic purchases in a rising price environment, to expect spending acceleration is a stretch.

2. Household debt is at 112% of income, roughly 28 percentage points higher than where it was in 1990s. The de-leveraging process is alive and kicking, and the household income portion of the balance sheet is failing to keep pace.

3. 3% or greater GDP growth is needed to create a strong amount of jobs. Revisions to prior GDP figures were deep, and estimates for 2H are being dropped by economists, and possibly, by the Fed shortly. The jobs outlook is murky, especially considering state government jobs have vanished (in Office Depot's earnings call there was sales weakness in California attributed to job reductions) and now Federal jobs are in play (also a ripple effect, say government cutting the defense budget may trigger job losses at various contractors).

To make the call that a consumer cocoon is morphing into a bright, butterfly-like recovery there has to be some indications of healing on the macro scene. Unfortunately, the external signs are not materializing just yet, so investing in consumer discretionary and household staples names should be approached with careful fundamental scrutiny (relative outperformance is something to pay attention to for when the macro situation improves, companies that outperformed in tough times will outperform even more in buoyant periods). Food for thought is to zero in on dollar stores at cheaper valuations following their poorly received most recent earnings reports. With Social Security and Medicare likely teed up for fundamental changes, there could very well be a senior movement to scrimp dollars in all areas of the budget. Say goodbye to those cash filled birthday cards, kids!