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.
Look to retailing
Two industries that historically perform well during a rising US dollar and therefore a good US retail environment are dollar stores and auto retailing.
AutoZone, Inc. (NYSE:AZO) is the nation’s largest dedicated retailer of automotive supplies. It has more than 4,700 stores in 49 states and a sizable presence in Mexico. It is the most efficient operator among peers, with superb margins.
AZO Operating Margin TTM data by YCharts
Advance Auto Parts, Inc. (NYSE:AAP) has the least expansive network of the big three with 3,900 stores in 39 states. It lacks a major presence in the West coast. Margins are worse by a significant amount, but like AutoZone, Inc. (NYSE:AZO), it is well positioned to capitalize on continued demand from a record high in the average age of vehicles on the road at 10.8 years.
Both companies are seeing weakness in same-store-sales as tough comps and increased new car sales remain viable headwinds. The stocks have been sluggish in the last year following several years of out-performance. Will a strong dollar be the impetus to get them moving higher again? Valuation has come down to more average levels in recent months and doesn’t appear to be a headwind moving forward. Why is Advance Auto Parts, Inc. (NYSE:AAP) trading with a similar multiple despite the weaker operational performance? This could be due to the fact that it appears on several LBO screens given its relatively manageable market capitalization of $5.8 billion and opportunity for operational improvement.
AZO PE Ratio TTM data by YCharts
Investment implications
As shown above, consumer discretionary stocks continue to indicate a market that is not imminently facing a reversal from the cyclical bull that has propelled stocks to record highs. Certainly gyrations and pullbacks are going to happen, but as has been the case since March 9, 2009, each pullback has ultimately led to higher highs. There is no evidence to suggest this is about to change. The facts from my previous three articles on stock market indicators highlight this case: When high-yield bonds, the yield curve, and consumer discretionary relative strength are all giving a green light, it is clear that investors should be fully allocated to U.S. equities. The retailing industry, specifically auto retailing, makes for a viable source of new investment capital.
The article Why the Bull Market in Stocks Is Far From Over originally appeared on Fool.com.
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