Why Consumer Discretionary Is A Mixed Bag

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Includes: VCR, XLY, XRT
by: Matthew Allbee

Summary

I will be doing a study of each sector of the U.S. economy. This article covers the Consumer Discretionary Sector.

The strength of the American consumer is very important to this sector.

The strong consumer of the past five years has kept Consumer Discretionary strong.

Interest Rates also have an inordinate impact on Consumer Discretionary stocks. It is important for investors in this sector to keep an eye on them.

Over the next week or two, I will be writing an article on each of the sector's of the U.S. economy. In each article, I will discuss the different aspects that tend to influence each sector, and their current status. In this first article, I will begin by discussing the Consumer Discretionary sector.

Consumer Discretionary

According to Investopedia.com, the Consumer Discretionary sector is the "sector of the economy that consists of businesses that sell nonessential goods and services." Because the goods are, by nature, discretionary, this sector is especially vulnerable to changes in consumer spending. So, let's start by taking a look at the health of the American consumer.

Consumer Sentiment

Click to enlarge

The above graphic shows the Univ. of Michigan's Consumer Sentiment Index. This index, which shows the current view of consumers on the health of the economy, has been in an uptrend since early 2010. This is important for companies involved in Consumer Discretionary industries, because consumers won't engage in discretionary spending if they believe the economy is on unsteady footing. By signaling that there is an increased willingness of consumers to spend discretionarily, rising consumer sentiment is a very bullish sign for the Consumer Discretionary sector. The closely related Conference Board Consumer Confidence Index has also risen significantly over the same time frame.

Unemployment/Wages

Another important economic variable to businesses involved in this sector is the income of potential consumers. If people are making less money, they obviously won't be able to spend as much on discretionary items.

Both unemployment and average weekly earnings have been improving in the U.S. since 2010. The unemployment rate has fallen to and is hovering around 5%, about the estimated natural rate. Similarly, the average weekly rate has been increasing in nominal terms at about $15/year to $870.78.

According to this model, which is based on econometric analysis and analyst expectations, unemployment should remain around 5% for the remainder of 2016. This model also forecasts that nominal wages should continue to grow at around their current rate for at least the remainder of 2016.

If unemployment does stay around 5% with wage growth continuing along the current trend, this will be good news for the Consumer Discretionary sector and the stocks that represent it.

Interest Rates

Under most economic frameworks, it would be expected that the percentage of income that is saved would increase as interest rates rise, because higher interest rates would provide a greater incentive for people to save. Since saving and consumption are inverses, and discretionary consumption is by definition the first thing consumers would cut out of their budgets when choosing to spend less, the Consumer Discretionary sector should be especially vulnerable to interest rate changes.

According to a Fidelity study of Consumer Discretionary stocks (which is good reading in its own right), these equities have indeed underperformed during cycles of rising interest rates. If you are investing in these names, it is especially important to stay informed about possible interest rate changes.

Valuation

According to this report by Yardeni Research, the average P/E for a Consumer Discretionary stock has been about 15 since 1997. This report, which was released on January 20th, lists the current average P/E at 16.6, these stocks would have to fall about another 9% to be at their average valuation.

Another 9% would definitely be a pretty large decline considering how far markets have already fallen. With interest rates still at historically low levels and the American consumer remaining strong, though, this valuation starts to make sense. Since the Fed is still projecting rate hikes throughout 2016, now may not be the time to jump into Consumer Discretionary. But, should the Fed outlook change or prices fall a few percentage points below their average P/E, you might be able to catch the beginning of an outperforming sector.

If you decide to invest in this sector, looking at broad Consumer Discretionary ETFs, such as from TheStreet's "Top 10 Consumer Discretionary ETFs" is a good place to start. For convenience sake, I'll summarize the top 3:

#3 (NYSEARCA:VCR) Vanguard Consumer Discretionary ETF: This ETF attempts to track the "MSCI US Investable Market Consumer Discretionary 24/50 index, which consists of small, medium, and large companies in the consumer discretionary sector." It has an expense ratio of 0.1% (updated from article) and AUM of $373 million (not updated).

#2 (NYSEARCA:XRT) SPDR Retail ETF: This ETF attempts to track the S&P Retail Select Industry Index. It was launched in 2006 and has an expense ratio of 0.35% (not updated) and AUM of $655 million (not updated).

#1 (NYSEARCA:XLY) SPDR Consumer Discretionary ETF: This ETF tracks Consumer Discretionary Select Sector Index. It was launched in 1998 and has an expense ratio of 0.19% (not updated) and an AUM of $2.6 billion (not updated).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.