By Michael Brush
It’s time to buy consumer-discretionary stocks.
Why? Investors hate them so much, they now look attractive.
Beyond the contrarian angle, here’s the high-level reasoning. When inflation rages, consumers get scared. Investors notice the weak sentiment and sell consumer stocks. But if inflation has peaked, that means these dynamics will reverse and the stocks will go up.
That’ll most likely be the case.
Inflation was largely caused by supply chain issues, demand shocks from excess stimulus, and the Ukraine war-related spike in commodity prices. Now, supply chains are being repaired, “stimmy” checks and Fed stimulus are history, and the worst of the war impact on commodity prices is probably behind us. This tells us inflation will slow. As that becomes apparent, consumer confidence will improve, and consumer-discretionary stocks will outperform.
That’ll be a major reversal, given how deeply they have lagged. The Consumer Discretionary Select Sector SPDR Fund /zigman2/quotes/200844504/composite XLY -1.70% was recently down 27% year to date, compared to a 10% decline for the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA +0.23% , a 14% drop for the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.16% and a 24% slide for the Nasdaq /zigman2/quotes/210598365/realtime COMP -0.50% .
Let’s look at the key concepts in more detail, and then we’ll get to some stocks favored by experts in the industry and corporate insiders.
Inflation is peaking
There’s a strong signal in the forward pricing of bonds (that is, expected interest rates) telling us that inflation has peaked and will fall sharply over time, notes Mark Zandi of Moody’s Analytics.
“Bond investors, who put their money where their mouth is, give us what is arguably the best measure of inflation expectations,” he says.
The “five-year forward” inflation expectations have fallen to near 2.5%, the upper end of the Fed’s target for CPI inflation, as you can see in this chart from Zandi. “With inflation expectations contained, inflation will recede,” he says.
Five years may seem like a long time. But it’s the directionality of inflation rates that matter for consumer discretionary stocks. Though, of course, I’m not suggesting consumer-discretionary stocks as day trades.
Inflation, sentiment and consumer stocks
To see why inflation matters so much for these stocks, consider history. Leuthold group strategist and economist Jim Paulsen recently took a look back and found that major spikes in inflation since the 1950s were linked to significant periods of underperformance by discretionary stocks.
Check out the chart below. Inflation is in red on an inverted scale, which means when the red line heads lower, inflation is higher. As you can see, there’s a pretty close correlation.
By the same token, consumer-discretionary stocks nearly always outperform when inflation declines, as you can see in the next charts.
“Most of the sizable declines in inflation led to important periods of leadership among discretionary stocks,” says Paulsen.
The reason is that consumer confidence rises as inflation declines. “Higher consumer-confidence levels, which lead to more robust spending, have traditionally been coupled with better performance from discretionary stocks,” says Paulsen. “If inflation tops out and confidence rallies, discretionary stocks could embark on a sizable leadership run.”
The box on the right shows consumer-discretionary-stock returns in the year after each inflation peak. The chart on the left maps inflation peaks since 1950.
Of course, to buy consumer-discretionary stocks, you have to believe the economy is OK and not going into recession, and that consumers have the strength to spend. Both are probably true.
First, the economy. Although economic indicators like business activity, shipments and orders declined in May, business surveys still indicate “a solid pace of growth,” says Goldman Sachs economist Jan Hatzius.