Here we are, deep into the all-important season for U.S. retailers, as year-end holiday sales will make or break the bottom line for many consumer-oriented companies—particularly many of those in the Consumer Discretionary sector. So it only makes sense that we review our current outlook on the sector this month. Spoiler alert! Based on the foundational building blocks that help inform our views on sectors, we’re maintaining a neutral rating.
In this article, we’re going to run you through the process by which we make our calls on the various sectors. We use an evidence-based, systematic process to identify factors that have historically provided insights into future performance. Because the economy and markets are constantly evolving, we overlay a heuristic element to account for the dynamic landscape.
Above is a quick summary of our Consumer Discretionary research before jumping into more detail below. With uncertainty surrounding the current economic outlook, it is hard for us to judge the macro economic landscape as anything but neutral. Amid the overconcentration of internet companies in the sector and a weakening sales outlook, we judge the fundamentals to be neutral for the Consumer Discretionary sector, as some of the core underpinnings of the fundamentals remain positive. The valuation factors are also neutral for the sector, as the average of multiple indicators rank Consumer Discretionary in the middle of the pack. In terms of behavioral factors, momentum is leaning negative for the sector, but strong upcoming seasonal influences bring our score up to neutral.
Behavioral score: Momentum negative, seasonal positive
While all eyes are on estimated sales throughout December, sector performance for the month is historically not impressive. After a typically strong November, when investors anticipate holiday sales, the sector historically posted positive relative performance in December 53% of the time, with average relative return of 0.07%. But the season doesn’t stop there, as things really heat up in the Consumer Discretionary sector in the first quarter, when earnings reports come in. That’s when the sector receives some seasonal tailwinds. Relative returns are typically positive, with average gains between 0.56% and 0.70% in January through March. Remember, these are relative to the returns of the S&P 500® Index, so these averages don’t imply that the absolute performance was up or down during the calendar months.
Historically, December is not the best month for Consumer Discretionary outperformance
Source: Schwab Center for Financial Research, Bloomberg, as of 11/29/2019. Data covers time period from January 1990 through November 2019.
While the monthly returns can provide some insights into seasonal patterns, they are the long-term average monthly returns. Like in 2019, performance can and often does deviate, as we saw in November, when Consumer Discretionary underperformed the overall market despite November being a historically strong month.
While the seasonal patterns are interesting and might provide a tailwind or headwind at times, our research shows that momentum can help provide a clearer picture of expected performance. Heading into the new year, it is sending a less-optimistic signal than upcoming seasonal patterns are providing. As the chart below depicts, relative performance momentum has turned quite negative.
Therefore, we are considering the behavioral factors like these to be net neutral at this time.
Relative performance momentum has turned negative
Source: Schwab Center for Financial Research, Bloomberg, as of 11/26/2019. 28-year average (01/01/1990 through 12/31/2019) shows the sector’s average monthly performance relative to the S&P 500 index since January 1990. Chart is meant to illustrate direction of change throughout the calendar year, more than the percentage change, and the vertical axis scales are adjusted to reflect that.
Macroeconomic conditions: Mixed, heightened uncertainty
Consumer discretionary is—unsurprisingly—one of the most cyclical sectors. As the name implies, it’s dominated by companies that produce products and services that consumers often do without when they are under financial stress or worried about their job security, such as new clothes, new cars or entertainment. While the relative performance of the sector is typically the strongest and most sustained in the early stage of the business cycle, historically there have been real or perceived mini-cycles within each broad business cycle. And those, in part, can periodically influence the sector’s performance against the broad market throughout the full cycle.
The U.S. economy likely will remain split early in 2020, with manufacturing and business investment still struggling amid trade uncertainty, but services activity and consumer spending remaining healthy. The question remains, if some of the trade risks subside, could the Federal Reserve’s “insurance” interest rate cuts in 2019 tip the scale in favor of renewed strength in the economy? We’re frankly not sure. However, what we do see is a slowdown in consumer spending in recent months, and that is consistent with the pullback in the Leading Economic Index (LEI) year over year.
Consumer spending and the LEI historically have tended to follow a similar pattern
Source: Schwab Center for Financial Research, Bloomberg, as of 10/31/2019
Yet the consumer remains relatively strong. Consumer confidence is high, household savings is high, and the job market—notwithstanding a few cracks—has been quite strong, with initial weekly jobless claims (a forward-looking indicator) remaining near record lows. While we are monitoring some leveling-off in claims and some other key employment indicators, the path may be dependent on a recovery of business confidence and investment. That might provide us some insights as to the upcoming relative performance of the Consumer Discretionary sector.
For now, the macro environment is not providing a compelling-enough rationale to label the macro factor landscape as anything but neutral for the Consumer Discretionary sector.
Fundamentals: Mix with weakening sales growth, yet still-strong return on equity
Of course, macroeconomic conditions can, in part, drive the industry fundamentals. The current easing in consumption is having an impact on sales expectations for the Consumer Discretionary sector. And as you can see in the chart below, year-over-year relative performance of the sector compared with the S&P 500 tends to move in the same direction as sales growth over time.
Consumer Discretionary relative performance tends to track sales trends
Source: Schwab Center for Financial Research, Bloomberg, as of 10/31/2019
However, the mix of retail has been shifting rapidly, with online sales growing much faster than traditional department store sales. The chart below reflects the percent of retail sales that comprises non-store (i.e., online) retail sales. As one might expect, the online retailers are creating significant price competition, which has created a tough environment for many retailers, especially those that rely more on sales from physical stores instead of internet shopping.
During the past 20 years, online sales have grown to more than 20% of retail sales
**Retail sales excluding food service, gas, building materials and motor vehicle dealers
*Electronic shopping and mail order houses
Source: Schwab Center for Financial Research, Bloomberg, as of 09/30/2019.
This has had an outsized impact on the Consumer Discretionary sector, as well. Since 2009, internet sales have grown from being 6.3% of the sector to over 20%. In terms of the market cap representation within the sector, 11 of the largest companies constituted 50% of the sector in 2009, with the largest single company (McDonalds) representing 7.6%. Now, just the top four companies comprise 50%, with the largest company (Amazon) coming in at nearly 30% of the weight. As we see a concentration of a sector like this, it leaves open the possibility that company-specific factors have an outsized influence on the overall sector relative performance and fundamentals. That’s something that we have to consider when assessing an overall sector.
While revenue growth in the sector is being driven in large part by the internet sub-industry and may be softening, return on equity (ROE) is more evenly dispersed across the sector and is currently among the highest of all of the sectors. This has historically been a long-term tailwind for the various sectors.
Despite concerns about overconcentration in the sector and a weakening sales outlook, we judge the fundamentals to be neutral for the consumer discretionary sector, as some of the core underpinnings of the fundamentals remain supportive.
We consider valuations for the various sectors by viewing the distance of multiple indicators from their historic mean relative to the S&P 500 Index. We do this for two reasons:
- There is not any one valuation metric that best characterizes true valuations, so we take a diversified approach by assessing six different indicators related to historical and expected earnings, the cash flow statement, and the balance sheet.
- We want to common-size the metrics for each sector by measuring the standard deviation from each sector’s mean for each indicator. Some sectors have a naturally low price-earnings ratio or high dividend yield, for example, so we can compare apples to apples by comparing each to its own history.
Consumer Discretionary is in the middle of valuation rankings
Source: Schwab Center for Financial Research, Ned Davis Research, as of 11/29/2019
Rankings based on analysis of multiple valuation metrics for each sector relative to the S&P 500 index. The Real Estate sector is not included in this analysis.
Currently, the consumer discretionary sector falls in the middle of the pack in terms of the valuation rankings. In our experience, it is typically the extremes in valuations where we tend to see a long-term impact. Interestingly, when doing the same analysis on an equal-weighted basis—thereby reducing the dominance of the internet industry group—the relative ranking of the Consumer Discretionary sector improves only slightly. That means that the large presence of the internet industry is only marginally skewing the relative valuations metrics.
Bottom line, valuations for the consumer discretionary sector are neutral.
Our overall sector views: Overweight Health Care, underweight Communication Services
We are currently maintaining a neutral view on most of the sectors, as our research has painted a mixed landscape with little conviction for many areas of the U.S. equity market. The exceptions are an overweight to Health Care and an underweight to Communication Services. Please visit the individual sector articles for synopses on all 11 sectors.
A final word
Keep in mind, no matter what our view is on any of the sectors, remaining diversified is very important. Concentrating in too few sectors can dramatically affect the risk profile and performance of your portfolio. So if you do make any sector tilts in your portfolio, keeping them small is a good way to maintain appropriate diversification and potentially enhance the performance of your portfolio.
Source: Schwab Center for Financial Research, FactSet (for YTD total returns) and S&P Dow Jones Indices (for S&P 500 sector weightings). Sector performance data is based on total return for each S&P 500 sector subindex (see “Important Disclosures” for index definitions). Sector weighting data is as of 11/29/2019; data is rounded to the nearest tenth of a percent, so the aggregate weights for the index may not equal 100%.
Past performance is no guarantee of future results.
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
*As represented by the S&P 500 index
Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news. Supporting documentation for any claims or statistical information is available upon request.
All expressions of opinion are subject to change without notice in reaction to shifting market or other conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Investing involves risk including loss of principal.
The Schwab Center for Financial Research (SCFR) is a division of Charles Schwab & Co., Inc.