Consumer Discretionary Stocks: Trade With Caution

Trade With Discretion
 
Last year, the S&P 500 rocketed 29.6% higher. Impressive.
 
But the real profit bonanza erupted in the consumer discretionary sector.
 
Companies that provide non-essential goods and services (think department stores, restaurants and entertainment companies) rose 41%, on average.
 
Standout performances by Netflix (NFLX), up 298%, and Best Buy (BBY), up 242%, certainly helped.
 
It’s not like a few stocks are unfairly skewing the results, though. To the contrary, the strength in the sector was broad based and perfectly rational.
 
Consider: In the last year, the economic recovery chugged along. Personal finances kept improving. (The ratio of household debt payments to disposable income fell to a 35-year low.) Consumer confidence rose. And inflation, well, remained non-existent.
 
In other words, Americans found themselves more optimistic, with more disposable income, and they spent it on affordable goods and services.
 
Now, consumer discretionary stocks should benefit the most under such conditions. And they did. But that’s all about to change…
 
The Sky isn’t Falling

No, I’m not suggesting an economic collapse is afoot that’s going to send consumers back into hibernation. Far from it.
 
Lest you forget, in early December, based on the latest automotive sales data, I went out on a limb to declare that the U.S. economy was strengthening.
 
A few weeks later, the Commerce Department confirmed it, revealing that U.S. GDP growth in the third quarter climbed to a healthy 4.1% annualized rate, well ahead of expectations.
 
Fast forward to today, and my bold prediction seems rather pedestrian…
 
Quoting a recent report from UBS’ Managing Director and Chief Economist, Maury N. Harris, Barron’s says that the economic “momentum is palpable.”
 
Jim Paulsen, Chief Investment Strategist at Wells Capital Management, concurs. In a recent note to clients, he predicted that U.S. economic growth “will quicken more than most anticipate.”
 
It goes without saying that a stronger economy promises to lift wages. However, even though it’s completely counterintuitive, more income in the hands of consumers won’t be a boon to consumer discretionary stocks. Here’s why…
 
Consumer Discretionary Headwind #1:

Bounce Already Baked In
 
The stock market is a forward-looking beast. And it figured out long ago that resurgent home values, slumping gas prices and an overall improvement in economic conditions would boost consumer spending.
 
Hence, the chart-topping performance for the economically sensitive stocks.
 
Put simply, the upside to the highly anticipated acceleration in the U.S. economy is already baked into prices for consumer discretionary stocks.
 
Sorry. But the time to play the resurgence has passed. If you missed it, don’t chase performance. You’ll get burned.
 
Consumer Discretionary Headwind #2:

Rising Incomes, Rising Costs
 
With 13 states set to raise their minimum wage in 2014 – and another 11 considering it – U.S. workers stand to be more flush with cash than in previous years, relatively speaking.
 
However, rising incomes for workers means rising labor costs for employers. And consumer discretionary companies can’t afford to absorb those increases.
 
As Bank of America’s (BAC) Equity Strategist, Savita Subramanian, points out, the sector is already the most labor-intensive one in the S&P 500.
 
Sales per worker at some consumer discretionary companies check in as low as $63,000 – and average about $233,000. For comparison’s sake, average sales per worker in the energy sector reach about $1.8 million.
 
More damning still, profitability in the consumer discretionary sector rests near historic highs. Current operating margins of 10.6% are just a stone’s throw away from the long-term ceiling at 11.1%, according to Subramanian.
 
Add it all up, and after years of relentless cost cutting, there’s no more “fat” to trim to increase profits. So as incomes rise, total costs for consumer discretionary companies will, too, as they can’t offset the pay increases with other cuts.
 
In turn, profits will be squeezed. And that’s bad news for stocks since they ultimately move in lockstep with profits.
 
Consumer Discretionary Headwind #3:

Stretched Valuations
 
After the price-to-earnings (P/E) multiple for the S&P 500 expanded from about 14.5 to 17 in 2013, pundits want to scream that we’re in another stock bubble.
 
In comparison, though, consumer discretionary stocks are almost 25% more costly. In fact, they’re the most expensive stocks in the market, trading hands for close to 22 times earnings.
 
Trying to buy high and sell higher is a fool’s game. But if you want to bet on consumer discretionary stocks like Wendy’s (WEN), which rallied 89% last year and trades at a P/E ratio of 91, go for it!
 
Come 2015, though, you’ll no doubt be asking, “Where’s the beef?”
 
Bottom line: After being the top-performing sector in 2013, consumer discretionary stocks are now the most expensive in the market. With both profit margins and valuations stretched, get ready for a disappointment of Biblical proportions.

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