Consumer Discretionary Sector: Cycle-Leading and the Amazon Effect

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Like the consumer staple sector we explored yesterday, the Consumer Discretionary sector includes a diverse array of industries. They include both goods and services offered in market segments such as:

  • Automobiles, and Auto Part Makers
  • Hotels/Restaurants/Leisure
  • Multiline Retail, Specialty Retail, Internet/Catalog Retail
  • Textiles & Apparel
  • Casinos and Gaming

So why would everything from hotels to new cars be lumped together? In short, because we perceive the demand for these goods as more income-sensitive than staple goods. A lower paycheck may barely affect a household’s grocery spending (or even increase it, as they eat more from home) while taking their spending on autos and hotels to near zero. We began exploring these “income elasticity” dynamics in yesterday’s blog post, and they work analogously here. While consumer discretionary stocks feature less stable cash flows, they also hold more growth potential than stocks from the Consumer Staples sector.

While Consumer Staples are thought of as a counter-cyclical sector, Consumer Discretionary stocks are generally thought of as a cycle leader. That’s because of the close relationship between consumer confidence and discretionary consumption. If consumers begin to doubt the state of the economy and fear a fall in income, we’d expect to see them cut back on non-essential goods first to bolster savings and pay down debt. We’ll see falling confidence hit sellers of these goods a step before it hits the industries in their supply chain.  The Discretionary sector, then, is theoretically going to over-perform when markets are on the upswing and underperform when markets hit a down-cycle.

Like other pro-cyclical stocks, we’d expect to see this sector be a bit vulnerable to macroeconomic variables (like interest rates). That’s not because consumer spending is highly sensitive to interest rates, but because investors at large are so wary of this sector’s tendency to lead business cycles. Higher rates represent a hot economy, which means discretionary spending will have nowhere to go but down as the economy cools. Lower rates suggest policymakers will be trying to continue stoking income growth in the economy—income we’d expect to see spent on discretionary items.

This diverse sector is also a great opportunity to remind ourselves how broad these sectoral categories can be. Most investors, for instance, would describe Amazon as a “tech giant.” We find this mega-retailer, however, in the consumer discretionary sector. That categorization makes sense at some level, with Amazon’s core model as a consumer goods marketplace. But it’s worth noting that Amazon makes a huge portion of its revenue from cloud computing services—an area with little practical connection to the Consumer Discretionary sector as it’s traditionally envisioned. And, with Amazon operating with a market cap almost 4x that of the next largest Consumer Discretionary stock (Home Depot), those cloud computing revenues end up being a non-trivial part of this sector (Amazon overall makes up over 15% of the sector’s market cap).

Complexities like this force us to recall that sectoral categorizations are always just a starting point for analysis. They’re a great tool, for instance, when trying to make apples-to-apples comparison between key valuation metrics. But focusing on the macro-dynamics of sectors without researching specific firms can lead to some misleading conclusions.

True to their reputation as cycle-leading stocks, discretionary stocks have been market-beating performers during the current economic expansion. Consequently, they’ve been a consistent source of strong news-based profits for our users.   If you’d like to learn more about using quantitative analysis and real-time news data to find market-beating profits in every sector of the stock market, we recommend one of our totally free virtual training seminars. You can claim your space in our next session using the button below:

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