The Consumer Discretionary Sector Will Outperform In 2019, Where Should You Put Your Money?

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Includes: AAPL, AMZN, BBY, CMCSA, DG, DLTR, EBAY, ETSY, FDIS, FXD, GHC, HD, IRBT, JPM, KSS, LYV, MCD, NKE, RCD, RST, SBUX, SPY, TGT, TRCO, VCR, WMT, XLY
by: Thomas Hughes
Summary

The consumer discretionary sector will be a market leader in 2019.

Earnings, earnings growth, and earnings growth acceleration will be the drivers.

Consumer health is as strong, supported by labor trends, and leading to sustained spending increases.

But don't invest in the Consumer Discretionary SPDR (if you already own other ETFs), there are better ways to gain exposure to this sector.

These two stocks will outperform the sector.

The Consumer Discretionary Sector will be a market leader in 2019. The sector will be driven by sustained improvement in consumer spending that is in turn supported by labor-market health, wage increases, and the outlook for earnings growth.

If you don't believe me, believe Jamie Dimon. In his remarks and comments regarding JPMorgan's (JPM) Q4 earnings release, Dimon said the US consumer is healthy and engaged.

While the Consumer Discretionary Sector SPDR (XLY) is an obvious choice for investment, it isn't the best choice for most investors.

Earnings Growth And Earnings Growth Acceleration Are In The Forecast

When it comes to the market, market value and stock prices earnings are the most important factors. In my last article, I detailed the earnings outlook for 2019 and 2020 looking for the top three sectors I need to own this year; Consumer Discretionary is one of them.

In terms of earnings growth, the discretionary sector is expected to be the #2 producer in 2019. The full-year consensus estimate is just shy of 9.5%, including a brief dip into contractionary territory in the first quarter. The dip into contractionary territory, if it comes to pass, will be a buying opportunity.

sector level earnings outlook 2019

Looking at 2019 on a quarter-by-quarter basis earnings growth slowdown is expected to bottom in the first quarter of this year and then slowly accelerate over the next two quarters. The final quarter of the year we should see earnings growth surge across the broad market and that growth will be led by Consumer Discretionary (and industrials and financials).

quarterly earnings outlook 2019

Jobs, Wages, Spending, 'Nuff Said

Consumer health is driven by the labor market; when people are working, they have money when they have money and are assured of earning more they spend. The data agree; Labor Trends Point To A New All-Time High For The S&P 500.

The number one labor market indicator, the Kansas City Federal Reserve's Labor Market Conditions Index, a composite index of 24 labor market indicators, is trending at the highest levels in over a decade and consistent with above-average economic growth.

labor market consumer spending

The last read, for December, shows activity increased and momentum remained very high. This reading is consistent with sustained above-average economic growth with peaks to 5% and higher. Looking back over the historical data is easy to see that this indicator (by rising above zero) has accurately predicted every significant period of economic expansion in the US since it was initiated.

The NFP report is important because it shows sustained job gains averaging 200K per month. It is more important because of unemployment, the number of persons coming back to the workforce, the labor force participation rate, and average hourly earnings.

The data shows jobs increased by 312,000 but unemployment jumped 0.2%. In most cases, a rise in unemployment is a bad thing but in this case, it's a great thing. The rise in unemployment was due to an increase in the number of unemployed persons, 276,000, which is evidence discouraged and long-term unemployed are coming back to the work-force.

The labor force participation rate was virtually unchanged because job gains and labor force gains were enough to cancel each other out. The salient point here is that the labor force, due to the US ever-increasing population, is the largest it's ever been, and growing.

Wages are also growing, posting greater than 3.0% YOY increases over the past three months and above 2.5% for more than two years, and that growth is fueling consumer spending.

We are not likely to see the most recent retail sales data due to the government shutdown but independent sources agree holiday sales were good (in a broad sense, not all retailers did so well).

The latest report is from Adobe. Adobe says online sales grew 16.5% during the holiday shopping season including Thanksgiving, Black Friday and Cyber Monday. Mastercard has already reported that total sales growth topped 5.1% which is slightly above expectation. The big winners in the space were Amazon (AMZN), Target (TGT), Walmart (WMT), Home Depot (HD), Best Buy (BBY), and eBay (EBAY) as they take share away from smaller stores and chains.

Buy The XLY, But Only If You Don't Already Own An ETF (Or Other Stocks)

The Consumer Discretionary Sector SPDR is a fine choice for investment but there is a caveat. If you already own other ETFs, or any of the top discretionary stocks, you probably already own a lot of what you will find in the XLY. A look at the top-ten holdings is a whose-who of mega-cap names that are so cross-diversified you may as well buy the S&P 500 (SPY).

The number one holding, Amazon, is nearly 22.50% of the total portfolio and one of the most heavily owned names on the market. It's part of FAANG and is better suited in a tech portfolio than in the consumer space. Sure, it is an online retailer but it doesn't produce anything and the consumer business doesn't really make money. The driving force in Amazon right now is AWS and the cloud which account for roughly 10% of revenue, the lion's share of free-cash-flow and nearly 100% earnings.

I'm not saying that Amazon isn't a good investment because it is, I'm saying you should look elsewhere when considering the bonanza of revenue and earnings that are coming down the pipe for the discretionary sector.

The top-five holdings of the XLY are rounded out by Home Depot (HD), McDonald's (MCD) (an automation story), Nike (NKE), and Starbucks (SBUX). Each is attractive in their own way but all are heavily owned and likely already represented in your portfolio so no reason to buy more.

These Consumer Discretionary ETFs Leave A Lot To Be Desired

You could turn to other ETFs like the Vanguard Consumer Discretionary ETF (VCR) but it's an identical twin to the XLY. The Fidelity MSCI Consumer Discretionary Index ETF (FDIS) is a little better but its top-five are identical to the XLY and VCR and the small changes in the second five aren't worth overexposing yourself to the other names in the list.

The First Trust Consumer Discretionary AlphaDex ETF (FXD) is a uniquely constructed consumer discretionary ETF with holdings heavily weighted toward entertainment. The top ten holdings include Tribune Media (TRCO), Graham Holdings (GHC), Comcast (CMCSA), Live Nation Entertainment (LYV), and Charter Communications (NASDAQ:CHTR). While these are all technically consumer discretionary stocks no single holding is more than 2.25% of the portfolio and there 110 total stocks; what you end up with is very well diversified ETF with no real focus.

The Invesco Equal Weight S&P 500 Consumer Discretionary ETF (RCD) is a lot like the FXD except its heaviest weightings are on the retailers. Kohl's (KSS) is in the top spot at 1.75% of the total portfolio, with Foot Locker (NYSE:FL), Dollar Tree (DLTR), Ross Stores (NASDAQ:ROST), and Dollar General (DG) rounding out the top five.

These Stocks Are Set To Outperform The Sector

ETSY - Etsy (ETSY) is my number one pure-play pick in the consumer discretionary space. The company is an online marketplace akin to eBay and one that is gaining traction among consumers. The Adobe retail report makes note of the company nabbing share from brick & mortar competitors, Goldman Sachs recently upgraded the stock based on an expectation of "relatively high returns and growth relative to valuation".

ETSY has been posting high double-digit quarterly revenue growth for more than three years (30% to 40%) while competitor eBay has been averaging less than 10%. In addition, over the past two years, revenue growth has exceeded consensus each and every quarter as adoption and use of the platform widens. At last report, active sellers were up 8.0% while active buyers were up more than 17%.

In terms of guidance, the company guided revenue higher at the last reporting and, based on strength in holiday sales, are likely to exceed their own outlook. The next earnings date is in early February, the stock is currently rising toward its all-time high and likely to move higher once earnings are released.

The only worry is that valuation relative to forward-earnings is quite high but it is a growth stock, and it's growing fast. Free-cash-flow is being reinvested as fast as they can make it and the return on investment is a high 150%.

iRobot - iRobot (IRBT) may technically be a technology stock but, like Apple (AAPL) is really a consumer products company that focuses on tech. The company has been producing high double-digit revenue increases and substantial EPS beats for quarters on end. The company's growth and earnings potential just can't be stopped.

At last report, the company said revenue grew by 28.8% and GAAP EPS more than doubled expectations on strength in legacy and new product lines. In the US, iRobot's strongest market, sales growth topped 45%.

The results allowed management to raise guidance (including the impacts of tariffs) for the full year to a range above the previous. Based on the holiday sales data there is a strong possibility the loftier guidance will be topped as well.

Analyst Troy Jensen issued a report at the beginning of January expecting the company to report strong results at next report. He says the new high-end line is selling exceptionally well and demand bodes well for average sales price and gross margins. The next earnings date is toward the end of January, I expect to see share prices for the stock drift higher until then. Over the next 12 months, iRobot will likely retest its all-time highs and move higher.

Whatever You Choose, Consumer Discretionary Is Going To Win In 2019

Whatever investment vehicle you choose the consumer discretionary sector is going to be a winner in 2019. The strength of the labor market, the health of the consumer, the trends in spending all point to the same thing; sales growth and earnings growth and that is going to drive the consumer discretionary sector to new highs in 2019.

S&P 500 Consumer Discretionary Index

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.