Consumer Discretionary

Yesterday's Weekly Report showed a table of sector operating margins relative to their long-term average, as well as price/sales ratios. Expensive sectors with above average margins appear particularly vulnerable in an environment where overall margins are being squeezed and economic risks are mounting. The consumer discretionary sector stands out as having significant profit margin and valuation downside. The policy backdrop is also turning more hostile. History shows that this sector outperforms when interest rates are falling and/or low, and underperforms when they climb and credit becomes more restrictive. This correlation is evident in the correlation between relative performance and money supply. When the cost of credit is low and liquidity is plentiful, investors discount increased discretionary consumer spending, particularly on durables, and bid stocks up accordingly. The opposite is also true. Currently, money growth is plunging, although remains in positive territory for the time being, suggesting that credit creation is slowing. Importantly, the longer that financial markets stay turbulent, the greater the upward pressure on the personal savings rate and likelihood that discretionary spending is reined in. Even then, a consumption contraction is not a prerequisite for consumer discretionary underperformance. With the Fed determined to keep pushing up interest rates, the macro backdrop is bearish for discretionary stocks.

An oversold bounce may be getting underway, but without a policy assist, it would be a rally to sell. Go to neutral in the growth vs. value trade and beware sub-surface weakness in the consumer discretionary sector.