Expectations that spending on items ranging from hotels to clothing will continue to rise have helped make consumer discretionary stocks the most expensive sector in the S&P 500.
Now fund managers are looking for ways to profit without getting burned, if a pullback comes on the back of worries about the coronavirus and other factors.
The consumer discretionary sector now trades at a forward price to earnings ratio of 24.2, well ahead of the 23.7 forward valuation of the technology sector, according to Refinitiv data.
Higher prices for consumer discretionary stocks come at a time when the broad S&P 500 trades at a forward P/E of 18.9, its most expensive valuation since 2002, according to Bank of America Global Research.
High expectations will be tested in the coming week as companies ranging from Macy's Inc to Marriott International Inc to Caesar's Entertainment Corp report fourth quarter earnings, giving investors a broad look at where consumers are choosing to spend their money and if there are any signs of a slowdown due to the coronavirus, now known as COVID-19.
Sellers on Amazon.com Inc, which constitutes about 26% of the sector, are already bracing for product shortages due to the spread of the virus among Chinese workers.
At the same time, consumer companies are among the most likely to be affected by rising U.S. wages. Goldman Sachs predicts wages will grow at a rate of 3.5% this year, putting additional margin pressure on companies that employ lower-wage workers. Average hourly earnings rose 3.1% in January compared with January 2019, according to the Bureau of Labor Statistics.
"We are now a consumer-focused economy and anything that affects the consumer will spread out to touch other sectors as well," said Moustapha Mounah, a research associate at James Investment Research. "We are looking for companies that can grow their market share without sacrificing their margins due to wage pressures."
As a result, Mounah is focusing on sectors such as homebuilders and discount retailers, both of which should benefit from low interest rates and the ability to pass on higher prices to their customers. At the same time, he is shying away from restaurants and department stores that have high fixed-costs and slim margins.
Overall, sales at clothing stores fell 3.1% in January, the biggest drop since March 2009, according to the Commerce Department, while overall core retail sales were unchanged.
Steve Chiavarone, a portfolio manager at Federated Hermes, said he is looking at discount retailers that have a strong perception of value as part of their brand identities, which will allow them to maintain high revenues even if the broad economy starts to dip.
"You are paying for the perceived safety and continued strength of the U.S. consumer," he said. By focusing on companies that are taking market share, investors can avoid the risk of an earnings or revenue disappointment, he said.
Overall, consumer discretionary companies are expected to increase their earnings by an average of 7.2% in 2020, a growth rate trailing projected gains in energy, healthcare, and technology stocks, according to Refinitiv data. For the year to date, the sector is up 6.2%, compared with a 3.8% gain in the broad S&P 500.
Bill Stone, chief investment officer at Avalon Advisors, said the high valuation of the consumer discretionary sector was a result of Amazon's outsized weight, with the company's 73 forward multiple bringing up the valuation of the sector overall. As a result, he is focusing more on companies in the sector like Macy's and cruise line operator Carnival Corp that trade at multiples of nine or lower.
"It's surprising to me that growth stocks have outperformed value by so much," he said. "At some point once the coronavirus outbreak passes we should get an acceleration in the economy and that should finally be the impetus for value stocks to catch up."
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