AutoZone, Inc. (AZO), Advance Auto Parts, Inc. (AAP), And Why the Bull Market in Stocks Is Far From Over

Consumer discretionary names such auto part companies, hotels, retailing, and media historically lead the performance of the broader based S&P 500. This is due to the importance consumer spending in GDP, at roughly 70%. The market will exhibit its usual gyrations, but investors should be concerned about a market top when consumer discretionary companies notably under-perform the S&P 500 for a three month period.

The graph below shows the S&P 500 Consumer Discretionary sector (orange line) under-performing the S&P 500 (white line) by 11% during the last quarter of 2007. For this indicator, I treat notable under-performance as anything more than a 10% divergence. At that point the S&P 500 was a meager 5% below its all-time high, corporate profits were exceptional, and a general feeling of bullishness was surrounding equities. Yet, an objective investor would be heading to the sidelines to avoid the ensuing 50% devastation.

A similar thing happened in 2000 prior to a further 35% collapse in the S&P 500 over the next twelve months.

Fool’s gold

Despite the great track record, this indicator alone is not foolproof. During the last five years of the super bull market in the late nineties, consumer discretionary stocks woefully under-performed the S&P 500. Technology shares were surging and their weighting in the S&P 500 would move from less than 15% to almost 36% in half a decade. This propelled the index to returns well ahead of the consumer discretionary sector alone. This is where leaning on the other two vital signs exhibited by high-yield bonds and the yield curve would have kept investors fully invested in surging equities, absent a brief moment in 1998 during the Russian financial crisis.

How to follow this indicator

The average investor likely doesn’t have access to a lot of expensive software, but they can still follow this important information. The most accurate method would be to visit standardandpoors.com or this link: add compare index and select S&P 500, choose a period of one year, export data to Excel, then compute returns for the last three months manually.

Alternatively, and much more easier, an investor can use the Consumer Discretionary SPDR ETF as a proxy. This ETF seeks to mirror the Consumer Discretionary Select Sector Index and will have performance very similar to the official S&P 500 Consumer Discretionary sector. This ETF is comprised of 82 names with 38% devoted to the retail industry and 29% to media. Here an investor can find the three month return with ease on sites such as Google Finance and compare it to the S&P 500. Currently the ETF has a three month return of 5% and the S&P 500 is 4% — no 10% divergence. This is a clear green light. Even better, the sector continues to outpace the broad S&P 500.