Opinion: Inflation has peaked – now is the time to look for bargain-priced consumer discretionary stocks

It’s time to buy consumer stocks.

Why? Investors hate them so much that they now look attractive.

Beyond the opposing viewpoint, here’s the high-level argument. When inflation rages, consumers get scared. Investors notice the weak sentiment and sell consumer stocks. But when inflation peaks, it means that momentum will reverse and stocks will rise.

That will most likely be the case.

Inflation was largely driven by supply chain issues, demand shocks from excessive stimulus and war-related spikes in commodity prices in Ukraine. Now supply chains are being repaired, stimmy checks and Fed stimulus are history, and the worst of the war’s impact on commodity prices is probably behind us. This tells us that inflation will slow down. Once that becomes apparent, consumer confidence will improve and consumer discretionary stocks will outperform.

That’s going to be a big reversal considering how badly they’ve lagged behind. The Consumer Discretionary Select Sector SPDR Fund XLY,
was recently down 27% year-to-date compared to a 10% decline in the Dow Jones Industrial Average DJIA,
a 14% decline for the S&P 500 SPX,
and a 24% decline for the Nasdaq COMP,

Let’s take a closer look at the key concepts, then move on to some stocks favored by industry experts and company insiders.

Inflation peaks

There is a strong signal in bond forward valuations (ie expected interest rates) that tells us that inflation has peaked and will fall sharply over time, notes Moody’s Analytics’ Mark Zandi.

“Bond investors who put their money where their mouth is give us arguably the best measure of inflation expectations,” he says.

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

Five years can seem like a long time. But it is her directionality of inflation rates relevant to consumer discretionary stocks. Although, of course, I’m not suggesting consumer discretionary as day trades.

Inflation, Sentiment and Consumer Stocks

To see why inflation is so important to these stocks, consider history. Leuthold Group strategist and economist Jim Paulsen recently looked back and noted that major inflation spikes since the 1950s have been associated with significant periods of discretionary stock underperformance.

Check out the chart below. Inflation is shown in red on an inverted scale, meaning inflation is higher when the red line is pointing down. As you can see, there is a pretty tight correlation.

For the same reason, consumer discretionary almost always performs better when inflation falls, as you can see in the next few charts.

“Most significant declines in inflation have led to key periods of leadership in discretionary stocks,” says Paulsen.

This is because consumer confidence increases when inflation falls. “Higher consumer confidence, leading to more robust spending, has traditionally been associated with better performance from discretionary stocks,” says Paulsen. “If inflation peaks and confidence rises, discretionary stocks could embark on a sizeable lead run.”

The box on the right shows consumer discretionary returns in the year after each inflation peak. The graph on the left shows inflation peaks since 1950.

recession risk

Of course, to buy consumer discretionary stocks you have to believe that the economy is fine and not going into recession, and that consumers have the strength to spend. Probably both are true.

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

Also, companies reported solid earnings and revenue growth during the first quarter earnings season.

“We believe that barring new adverse shocks, fears of a slowdown in economic activity this year will prove overdone,” he says.

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

purchasing power of consumers

As for the consumer, the labor market remains strong. And consumers have healthy balance sheets. “Excess savings,” or the portion of income saved, remains well above historical levels. And interest payments on debt remain remarkably low relative to income.

“In over 40 years of record, American families currently spend the smallest portion of their income making interest and principal payments on their debt,” says Zandi.

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

Consumer discretionary stocks to consider

In addition to exchange-traded funds such as the Consumer Discretionary Select Sector SPDR Fund, the Vanguard Consumer Discretionary ETF VCR,
or the Invesco Dynamic Leisure & Entertainment ETF PEJ,
There are several stocks and themes to consider here.

Invest in companies that sell experiences

Now that people are out of lockdown, they’re shifting spending on things at Amazon.com AMZN,
and Netflix NFLX,

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

Still, retail “services business” spending remains 5% below trend as weakness emerges in virus-sensitive categories like spectator events and travel, says Goldman Sachs’ Hatzius. That points to room for growth.

Klink highlights restaurant chain Chipotle Mexican Grill CMG,
and Hilton Hotels HLT,
Chipotle’s drive-through service, developed during the pandemic, remains a magnet. Along with increasing travel demand, Hilton will grow about 5% more rooms per year. Accommodation establishments are also a hedge against inflation as they can change the prices of rooms quickly.

Rely on pricing power

Pricing power is always a plus when investing. LVMH Moët Hennessy Louis Vuitton LVMUY,
has it in retail, one reason Cambiar investor Di Zhou likes the stock.

“Many 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 with luxury companies. They have pricing power and are not afraid to use it.”

She also likes the bias toward high-income consumers who have more savings, more spending power, and fewer concerns about inflation. This supports sales growth even in recessions.

Follow the insiders

It can pay off to follow company insiders in stocks. I’ve suggested most of the names below in my stock letter (link is below in my bio), where I give a heavy weight to buying by savvy insiders when considering investment ideas.

First, like our retail expert above, insiders direct us to companies that offer “experiences.” These are the service companies that are getting a boost because people ate too much of things during the pandemic.

On the Carnival CCL cruise line
A director with a good record recently bought $1.2 million worth of stock for $12.18 and in Norwegian Cruise Line NCLH,
A director bought $1.5 million worth up to $15.25 per share. These are nice signals that are reinforced by buying from two companies in the same space. According to Carnival, the week of March 28 was the busiest week in company history.

At Live Nation Entertainment LYV,
A director bought $268,000 up to $37.40. Live Nation recently announced that it sold more than 70 million tickets for Live Nation shows in 2022, up 36% or almost 20 million from the same point in 2019.

At the Texas Roadhouse TXRH restaurant chain,
Two directors, including one with a good record, recently bought over $700,000 worth of stock up to $71. In the first quarter, comparable restaurant sales increased 16% in company restaurants and 20.4% in domestic franchise restaurants.

But insiders also like consumer goods companies. At Crocs CROX,
Insiders, including the chief financial officer, bought $950,000 worth of shares at around $50 to $58. Revenue rose 47% in the first quarter, driven by the casualization trend in footwear 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 has proposed AMZN, NFLX, CCL, NCLH, LYV and CROX in its Brush Up on Stocks newsletter. Follow him on Twitter @mbrushstocks.

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