Consumer discretionary stocks, also known as cyclical stocks, are companies that produce goods and services that are considered non-essential or discretionary. These companies are heavily influenced by the business cycle and tend to perform well when the economy is doing well.
- The consumer discretionary industry is currently the second most profitable industry in the US market, behind the technology industry.
- Consumer discretionary companies produce goods and services that are considered non-essential or discretionary, as they are closely tied to consumer spending habits and overall economic conditions.
- Annualized 10-year return for Consumer Discretionary Select Sector Index is 11.52%, while that of the S&P 500 is 10.53%.
- The consumer discretionary industry may also be used to measure the health of the economy through factors such as the labour market, consumer confidence, and disposable income.
- Although consumer confidence has driven the consumer discretionary sector in a rally, it would be important to pay attention to the intrinsic value of the company and its ability to face a potential recession.
We may say that 2023 has been a successful year for the US stock market, mainly driven by the excitement around artificial intelligence. So it seems logical that the main winners will be in the technology sector. Meanwhile, other sectors, such as utilities, energy, and consumer staples, fall behind. The large discrepancy between the most favoured tech stocks and the broader market may be well illustrated by the year-to-date returns of main US indices. While the more tech-heavy Nasdaq Composite index has gained 29% from the beginning of 2023 until the moment of writing this article, Dow Jones Composite index has not reached even a 3% return in the same period, while the largely followed S&P500 index is somewhat in the middle with 13.45%.
Source: Simplywall.st
While there is no doubt about the tech industry and its AI wave, our attention has been drawn to the second most profitable US sector - consumer discretionary. This sector has returned almost 13% over the last month and 18.42% over the last year.
What exactly is the consumer discretionary sector?
Consumer discretionary stocks, also known as cyclical stocks, are companies that produce goods and services that are considered non-essential or discretionary. These companies are heavily influenced by the business cycle and tend to perform well when the economy is doing well. Consumer discretionary companies typically include industries such as retail, automobiles, leisure and entertainment, travel, tourism, and media. Examples of consumer discretionary stocks include companies like Amazon, Walt Disney, Nike, and Starbucks.
The performance of consumer discretionary stocks is closely tied to consumer spending habits and overall economic conditions. During periods of economic growth and rising consumer confidence, consumers tend to spend more on discretionary items like luxury goods, entertainment, and travel, which benefits these companies leading to higher growth profiles due to more robust cycles. Meanwhile, due to this reason, consumer discretionary companies tend to pay less dividends. However, during economic downturns or times of financial uncertainty, consumer discretionary stocks may face challenges as consumers cut back on non-essential spending.
Consumer staples stocks may be considered the opposite of consumer discretionary stocks. They are also known as defensive stocks, meaning they are less affected by economic cycles and tend to be more stable. These companies produce and sell essential products and services that consumers need regardless of the economic environment, such as food, beverages, household products, and personal care items. Consumer staples stocks are known for their relatively consistent demand and stable cash flows. Examples of consumer staples stocks include companies like Coca-Cola, Procter & Gamble, Nestlé, and Walmart.
Consumer Discretionary vs S&P500
Based on the above description, we could conclude that consumer discretionary stocks may be more volatile in comparison to the S&P500 index – growing faster in an expansionary environment and falling stronger during a recession.
However, when comparing the Consumer Discretionary Select Sector Index (white line in the chart below) to the S&P 500 (blue line), the story is less straightforward. While the Consumer Discretionary sector outperforms the S&P 500 during economic expansions, the downward pressure on the Consumer Discretionary sector during recessions has not been strong enough to drive its 10-year return below that of the S&P 500. In fact, the spread between Consumer Discretionary Select Sector Index and S&P 500 has turned negative just once – at the beginning of 2023 for a short moment. Overall, the annualized 10-year return for Consumer Discretionary Select Sector Index is 11.52%, while that of the S&P 500 is 10.53% allowing one to earn nearly 1 percent point higher return each year if invested in the consumer discretionary sector.
Source: S&P Dow Jones Indices
Consumer discretionary sector as an instrument to determine the state of the economy
Demand for consumer discretionary products tends to be more flexible than other products as consumer confidence, disposable income, and other factors change. Therefore, in addition to being a result of these factors, changes in demand for consumer discretionary products may serve as an additional indicator of the economy's overall health. Consumer discretionary spending represents a substantial portion of overall consumer expenditure. When the economy is thriving, consumers tend to have higher disposable income and seem more likely to spend on discretionary items. Therefore, increased consumer spending within this industry could indicate consumer confidence and a healthy economy. Similarly, strong demand for discretionary goods and services denotes that consumers seem willing to spend beyond necessities, indicating a healthy and expanding economy. Conversely, declining consumer discretionary spending could indicate a slowdown or recessionary conditions.
The consumer discretionary sector is also labour-intensive, employing a significant number of workers. When the economy is robust, businesses within this industry tend to expand and hire more employees. Additionally, rising wages could positively impact consumer discretionary spending, as individuals have more disposable income to allocate towards non-essential purchases. Therefore, this industry is highly influenced by consumer sentiment and confidence. When consumers are optimistic about their financial well-being and future prospects, they seem more likely to spend on discretionary items. Therefore, monitoring the performance of this industry can provide insights into consumer sentiment, which is essential for evaluating economic conditions.
The performance of consumer discretionary stocks may serve as a leading indicator for broader market trends. As discretionary companies generate revenue from consumer spending, their stock prices can reflect investors' expectations about the economy's overall health. Bullish performance in consumer discretionary stocks could signal optimism about future economic prospects. However, it needs to be pointed out that stock market returns are not a direct reflection of the overall state of the economy. As a recent example, the stock market fell in March 2020 when the Covid-19 pandemic had just spread around the world, but since then it has been on a bull run, reaching new highs despite countless people losing their lives or their jobs and a large part of the economy being shut down.
Conclusion
The above findings may lead to the following conclusion: although there are still many uncertainties related to rising inflation, interest rates, the banking crisis and the overall economy, consumers appear to be confident enough in their financial stability not to cut back on discretionary purchases. Furthermore, once the consumer discretionary industry starts to outperform the overall market (S&P 500), it may continue to do so for an extended period until a market correction occurs, such as in 2022.
Investors may want to take advantage of the consumer discretionary industry rally. However, it is important to keep in mind the still ongoing economic uncertainties and the potential for a recession resulting from a tightening monetary policy. Therefore, it is crucial to spot such consumer discretionary companies that not only "drive the industry's rally" but also have a strong balance sheet and experience to endure a potential recession and are not yet too overvalued due to the recent rally. Below are two consumer discretionary stocks that might fit the description.
- Amazon.com, Inc (AMZN) – a stock that might be not only in the list of top consumer discretionary stocks but also in the overall list of attractive investments. With an average target price of 139 USD, AMZN is among the few consumer discretionary stocks poised to benefit from the artificial intelligence boom due to its cloud computing unit, Amazon Web Services.
- McDonald's (MCD) – although a rather expensive stock currently trading just below 300 USD, MCD is said to be not only a consumer discretionary stock with all its benefits but also nearly recession-proof. Its price graph may prove this statement – the stock lost only 2.21% of its value by the end of 2022 compared to the beginning of the year. Meanwhile, it also reached a that-time all-time high of 281.67 USD in November 2022.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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