We recently compiled a list of the 10 Best Consumer Cyclical Stocks To Buy Now. In this article, we are going to take a look at where The Home Depot, Inc. (NYSE:HD) stands against the other consumer cyclical stocks.
Consumer cyclical stocks are highly correlated with the economic cycle. Ideally, you’d want to buy them near the bottom of a recession when their prices are lower, anticipating a recovery and rising consumer spending. Essentially, owning consumer cyclical stocks is a bet that the economy will be growing in the near future. This is in contrast to consumer staples, or consumer defensive, stocks which allow investors to position their portfolio to hedge losses in the case of an economic downturn.
Since consumer cyclical stocks are riskier than their defensive counterparts, they offer higher returns and also come with the corresponding increase in risk. Additionally, while determining the risk of consumer defensive stocks might be relatively easy and off the bat calculations can be used, conducting the same exercise for cyclical stocks is trickier. Investors determine a stock’s risk by calculating its beta (β), which measures the tendency of a stock to move with the broader market. Stocks with a β greater than one are more volatile, those with a β less than one are less volatile, and a few (like gold mining stocks) can even have a negative β that makes their share prices move in opposition to the market.
So why is measuring the risk of cyclical stocks tricky? Well, research shows that investors can either rely on a ‘reasonable’ β estimate of 0.7 for defensive stocks or narrow them down by stock sector to define a β that ranges between 0.6 to 0.8. On the flip side, similar shortcuts are unadvised for calculating the β for consumer cyclical stocks. To determine the risk of these stocks, a case by case approach that takes into account the earnings volatility of a firm and the overall business model is recommended.
Building on this, consumer cyclical stocks are dependent on the business cycle for their performance. In fact, data shows that if you’re able to time the business cycle, then investing in consumer staples stocks can provide an opportunity to lead all other market sectors in terms of return. The business cycle is broadly divided into four phases, the early, mid, late, and recession phases. Each phase is marked by unique economic characteristics, and research shows that consumer cyclical stocks perform the best during the first phase. This phase marks the start of a new business cycle after the previous cycle’s recession phase has ended, and its biggest traits are low interest rates and an uptick in economic activity.
Research shows that the first phase of the business cycle is the one that features the highest sector differentiated performance, with the difference between returns spreading to 25 percentage points. The stocks that lead the returns in this period are consumer cyclical stocks since lower interest rates and an uptick in economic activity allow consumers to have higher discretionary spending and enable businesses to expand operations through easy credit. The ‘hit rate’ (which measures the percentage of time periods in the business cycle periods in different cycles over time where the sector outperformed) of cyclical stocks during the early phase is 100%, which ties in with the performance of consumer staples in the late stage among all seven stock market sector performance across all phases of the business cycle. In terms of average returns, consumer cyclical stocks return roughly 12% as a category, implying that individual stocks will offer higher returns as the data is influenced by outliers to a large extent.
Since consumer cyclical stocks are dependent on business cycles to a large extent and also rely on robust consumer spending, the next step in analyzing their performance is to see how spending varies within the cycle. Estimating what stage of the business cycle we’re in is a tricky process, and analysts at the investment bank Morgan Stanley have tried to do so. Their research shows that we are currently in the downturn phase of the cycle, which precedes the early stage we’ve talked about above. We can also try to determine the business cycle’s stage ourselves. Right now, inflation is still trending above trend in America (2.6% PCE in May vs 2% preferred), first quarter GDP growth slowed down (1.6% in Q1 from 3.4% in Q4 2023), and inventories at retailers jumped by 1% annually in February. These three metrics suggest that we might be in the late stage of the business cycle which typically precedes a recession. Consumer spending slows down in the late stages of the business cycles, the downturn and the recession, and neither cycle stage bodes well for consumer cyclical stocks. A key indicator of consumer spending is consumer confidence as it indicates future economic perceptions. On this front, US consumer confidence in March, April, May, and June stood at 103.1, 97, 101.3, and 100.4, respectively. A lower value signals lower confidence, and a value under 80 can signal a recession.
Topping our analysis, let’s take a look at how consumer cyclical stocks have recently fared to check whether the conclusions we’ve reached above are supported by stock market performance. As a refresher, 2024 has been characterized by investors pushing forward interest rate cut expectations and seeking shelter in a few stocks characterized by their strong exposure to the artificial intelligence industry. Two of the most popular consumer staples and defensive stock indexes are those managed by the S&P. Looking at their performance over the past twelve months, these are up by 14.8% and 5.8%, respectively. This is unsurprising since the US GDP has defied expectations during this time period, as it grew by 4.9% and 3.4% in Q3 and Q4 2023 and beat analyst expectations.
However, Q1 2024 GDP growth slowed down to 1.6%, which not only missed analyst estimates of 2.4% but also came with some rather ill-boding expectations for consumer cyclical stocks as spending growth slowed down from its 3.3% growth in the previous quarter to 2.5% in Q1. This figure also sat well below Wall Street’s 3% estimate. The data was released in April, and the previous release which saw the 0.4% inflation reading for March outdo analyst estimates triggered a 6% drop in the consumer cyclical stock index over the next nine days. Since then, the index has gained 6.57%.
Our Methodology
To select the best consumer cyclical stocks to buy, we ranked the 40 biggest consumer cyclical stocks in terms of market capitalization stocks by the number of hedge funds that had held a stake in them during Q1 2024. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A home improvement store overflowing with a variety of products and supplies.
The Home Depot, Inc. (NYSE:HD)
Number of Hedge Fund Investors In Q1 2024: 70
The Home Depot, Inc. (NYSE:HD) is one of the biggest home improvement products retailers in the US. While most retailers are classified as consumer defensive stocks, The Home Depot, Inc. (NYSE:HD) is a cyclical stock due to its close ties to the real estate industry. The firm’s sales are dependent on activity in the building and construction sector, which typically performs well when interest rates and inflation are low. Consequently, it’s unsurprising that The Home Depot, Inc. (NYSE:HD)’s shares are down by nearly 2% year to date, with the sell off accelerating in April after the inflation data dented Wall Street’s hopes for interest rate cuts. The Home Depot, Inc. (NYSE:HD)’s latest financial report released in May was a clear example of macroeconomics playing a greater role in its woes than business specific factors as its comparable store sales fell by 2.8% during the quarter. This marked the sixth consecutive drop and it also overshot analyst estimates of 2.09% by a wide margin. To sum it up, while The Home Depot, Inc. (NYSE:HD) ‘s $3.7 billion in cash provides it the heft to weather out macroeconomic storms, unless the economic outlook brightens, expect little fireworks from the firm.
The Home Depot, Inc. (NYSE:HD)’s management also commented on the macroeconomic environment during its latest earnings call. According to them:
Clearly, we’ve seen two years of significant decrease in housing turnover to the point where we’re at really sort of at historical lows. And most folks think that, that can’t get much lower. When you’re thinking about current performance, obviously, that puts pressure on our business. When a customer buys or sells a home, they spend more in that year than in a year when they don’t. And so there’s no doubt that we’re missing some of that project demand, and that’s what’s going on our sales as we had anticipated. Then you have to ask yourself though, the lock-in effect, the interest rate environment, at this point, a lot of subject to the macro.
I think the question is at what point current interest rates become sort of the new normal. This is not something that we’re making a prediction on. It’s just thinking about behavior. At some point, spend on housing shifts from discretionary to something that you simply must do. We know that there’s pent-up demand for household formation. And so again, I’d say short-term, it is having an impact on our customers’ mindset. And it’s not just housing turnover related spend. It’s really all large projects. As Billy said, sort of debt finance spend where we are seeing interest rates sort of weigh on the mind of customers. And look, we’re not immune to this. If you look at the national figures on what’s really driving the consumer right now, its services.
Goods are underperforming services and durable goods are seeing the most pressure and in particular, home-related categories. So this is not a surprise and this is baked into our expectations for the year. The question will be how it evolves over time.
Overall HD ranks 10th on our list of the consumer cyclical stocks to buy. You can visit 10 Best Consumer Cyclical Stocks To Buy Now to see the other consumer cyclical stocks that are on hedge funds’ radar. While we acknowledge the potential of HD as an investment, our conviction lies in the belief that AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than HD but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.
