FMD Capital Management

How to Play Consumer Discretionary Stocks

Written by David Fabian, October 31st, 2013

The fourth quarter of the year is typically dominated by consumer activity.  We have several major spending holidays that generate billions of dollars in discretionary sales for retailers and product manufacturers.  In addition, many of these same companies pick up additional part-time employees that stimulate U.S. economic productivity more than any other time of the year.

We just recently received third quarter earnings reports from most of the major players in the discretionary spending sector, which contributed to a new breakout for many consumer stocks.

The question is:  how long will that trend last and what should we look for when consumer spending starts to falter?

Typically investors pay very close attention to the forecasted holiday sales numbers which can make or break a retailer’s year.  Early forecasts have predicted a year-over-year decline in holiday spending which will likely lead to big discounts and price wars among competitive brands.  In addition, we can likely expect the holiday shopping season to start earlier than ever this year as companies try to stimulate sales in anticipation of getting the jump on the competition.

One easy way to gauge the health of stocks that will be positively or negatively affected by this holiday demand is through the Consumer Discretionary Select Sector SPDR (XLY).  This ETF is made up of 86 large-cap companies that are primarily focused in the media, retail, automotive, and leisure spending categories.  The top three holdings include: Amazon (AMZN), Comcast Corp A (CMCSA), and Walt Disney (DIS).  XLY is by far the largest ETF in the consumer discretionary space with over $6.8 billion in total assets and an expense ratio of just 0.18%.

It should come as no surprise that with the health of the economy continuing to improve that consumer activity has remained strong through the balance of the year.  XLY has gained over 35% in 2013 which is outperforming the broader SPDR S&P 500 ETF (SPY) by close to 10%.  A quick look at the chart shows that nearly every modest pullback has been bought with gusto.  According to Index Universe, XLY has added nearly $1.7 billion in new assets which is a sign that investors are picking up an appetite for these growth stocks.

From a timing standpoint, I would not be surprised to see a continuance of this rally into the end of the year.  Often times the exuberance of consumer activity buoys stock prices and betting against these stocks has been an exercise in futility this year.  If you currently have an allocation to the consumer discretionary sector, I would continue to hold your position and ride the trend while using a trailing stop loss to lock in gains.  Let the trend be your friend.

Investors that are looking to put new money to work should wait for at least a modest pull-back to the 50-day moving average before making an allocation.  A break below the 200-day average would signal that a significant correction is under way and would be a caution sign against adding new money.  XLY hasn’t traded below its 200-day moving average in nearly 2 years as this uptrend has unfolded.

Any surprises in retail spending activity this year could certainly derail the current bullish enthusiasm.  I recommend approaching consumer discretionary stocks with cautious optimism and an eye towards risk management to ensure that you hold onto your gains for the remainder of the year.