Opinion: Inflation has peaked – now is the time to shop for consumer discretionary stocks

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 are afraid. Investors are noticing weak sentiment and are selling consumer stocks. But if inflation has peaked, this means that this dynamic will reverse and stocks will rise.

This will most likely be the case.

Inflation was largely caused by supply chain issues, demand shocks from excessive stimulus, and war-related commodity price spikes in Ukraine. Today, supply chains are being repaired, “timid” controls and Fed stimulus are a thing of the past, and the worst of the war’s impact on commodity prices is likely behind us. This tells us that inflation will slow down. As this becomes evident, consumer confidence will improve and consumer discretionary stocks will outperform.

It will be a major reversal, given how far behind they have fallen. The SPDR fund of the select consumer discretionary sector XLY,
recently fell 27% since the start of the year, compared to a 10% drop for the Dow Jones Industrial Average DJIA,
a 14% decline for the S&P 500 SPX,
and a 24% drop for the Nasdaq COMP,

Let’s take a closer look at the key concepts, then we’ll cover some stocks favored by industry experts and company insiders.

Inflation peaks

There is a strong signal in bond forward pricing (i.e. 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 they say, give us what is arguably the best measure of inflation expectations,” he says.

“Five-year” inflation expectations have fallen to nearly 2.5%, the upper limit of the Fed’s target for CPI inflation, as you can see in this chart from Zandi. “With inflation expectations contained, inflation will come down,” he says.

Five years may seem like a long time. But it’s the directivity inflation rates that matter for consumer discretionary stocks. Of course, I’m not suggesting that consumer discretionary stocks are day trades.

Inflation, Sentiment and Consumer Actions

To understand why inflation is so important to these stocks, consider history. Leuthold Group strategist and economist Jim Paulsen recently looked back and found that major inflation spikes since the 1950s were linked to significant periods of underperformance in discretionary stocks.

See the table below. Inflation is in red on an inverted scale, which means that when the red line goes down, inflation is higher. As you can see, there is a pretty close correlation.

Similarly, consumer discretionary stocks almost always outperform when inflation declines, as you can see in the following charts.

“Most of the big declines in inflation have led to important periods of leadership among discretionary stocks,” says Paulsen.

The reason is that consumer confidence rises as inflation falls. “Higher levels of consumer confidence, which lead to more robust spending, have traditionally been associated with better performance of discretionary stocks,” Paulsen said. “If inflation peaks and confidence picks up, discretionary stocks could embark on a major leadership race.”

The panel on the right shows the returns of consumer discretionary stocks in the year following each spike in inflation. The graph on the left maps inflation peaks since 1950.

Recession risk

Of course, to buy consumer discretionary stocks, you have to believe that the economy is doing well and not going into a recession, and that consumers have the strength to spend. Both are probably true.

First, the economy. Although economic indicators such as business activity, shipments and orders fell in May, business surveys still point to “a solid pace of growth,” says Goldman Sachs economist Jan Hatzius.

Additionally, the companies reported strong earnings and sales growth during the first quarter earnings season.

“We believe fears of a decline in economic activity this year will prove overblown unless further negative shocks materialize,” he said.

Hatzius forecasts growth of 2.8% in the second quarter, followed by an average of 1.6% over the following four quarters.

consumer purchasing power

On the consumer side, the job market remains strong. And consumers have healthy balance sheets. “Savings surplus,” or the portion of income saved, remains well above historical levels. And interest payments on debt remain remarkably low relative to income.

“In more than 40 years of record keeping, American families currently spend the smallest share of their income on interest and principal payments on their debts,” says Zandi.

Although consumer confidence has declined, it remains well above its pandemic lows and far from recession territory, notes Vance Howard, who manages the HCM Tactical Growth Fund HCMGX,
which far beats competing funds, according to Morningstar Direct.

Consumer Discretionary Stocks to Consider

Beyond exchange-traded funds like the Consumer Discretionary Select Sector SPDR Fund, the Vanguard Consumer Discretionary ETF VCR,
or the PEJ Invesco Dynamic Leisure & Entertainment ETF,
Here are several actions and themes to consider.

Invest in companies that sell experiences

Now that people are no longer confined, they are moving away from spending on Amazon.com AMZN,
and Netflix NFLX,

Instead, they’re spending more on experiences like dining out and travel, says David Klink, senior equity analyst at Huntington Private Bank.

Still, spending on “services” businesses in retail remains 5% below trend due to weakness in virus-sensitive categories like spectator events and travel, Goldman Sachs’ Hatzius says. This suggests room to grow.

Klink distinguishes Chipotle Mexican Grill restaurant chain CMG,
and Hilton Hotels HLT,
Chipotle’s drive-thru developed during the pandemic remains a draw. In addition to growing travel demand, Hilton will grow by adding approximately 5% more rooms per year. Accommodation companies are also a hedge against inflation due to their ability to quickly reprice rooms.

Opt for price power

Pricing power is always a plus in investing. LVMH Moet Hennessy Louis Vuitton LVMUY,
has it in retail, one of the reasons Cambiar Investor Di Zhou likes the stock.

“A lot of companies say they have pricing power, but either they don’t have it or they’re afraid to use it,” Zhou says. “It’s different for luxury companies. They have pricing power and they are not afraid to use it.

She also likes the tilt toward higher-income consumers, who have higher savings, more discretionary purchasing power, and fewer concerns about inflation. This supports sales growth, even during recessions.

Follow Insiders

It can be beneficial to follow company insiders in the stock. I have suggested most of the names below in my stock letter (you can find a link in my bio below), where I place great importance on smart insider buying when reviewing d investment ideas.

First, like our retail expert above, Insiders point us to companies that offer “experiences.” It’s the service businesses that are getting a boost because people have been overusing things during the pandemic.

To the Carnival CCL cruise line,
a director with a good record recently bought $1.2 million worth of shares at $12.18, and at Norwegian Cruise Line NCLH,
a director bought for $1.5 million up to $15.25 per share. These are good signals, reinforced by purchases from two companies in the same space. Carnival says the week of March 28 was its busiest booking week in company history.

At Live Nation Entertainment LYV,
a director bought $268,000 down to $37.40. Live Nation recently reported selling more than 70 million tickets for Live Nation 2022 shows, up 36%, or nearly 20 million, from the same point in 2019.

At the Texas Roadhouse TXRH restaurant chain,
two directors, one with a good record, recently purchased over $700,000 worth of stock at $71. First-quarter comparable restaurant sales increased 16% at company restaurants and 20.4% at national franchise restaurants.

But insiders also like consumer discretionary companies. At Crocs CROX,
insiders, including the CFO, bought $950,000 worth of stock at around $50 to $58. Sales rose 47% in the first quarter due to the casual footwear trend that began during the pandemic and the popularity of the Hey Dude brand.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned AMZN, NFLX, CCL, NCLH and CROX. Brush suggested AMZN, NFLX, CCL, NCLH, LYV and CROX in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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