Consumer Stocks: Can the Rally Last?

The stock market's recent rally has had an unlikely leader: consumer discretionary stocks.

The economically sensitive sector has shrugged off gloomy economic conditions as investors look to better times ahead. In the past 13 weeks, the Standard & Poor's 500-stock index consumer discretionary sector is up 23%, more than any other sector. Year-to-date through May 6, the sector had risen 10.5%, putting it in the top three of 2009 performers, along with the materials and information technology sectors.

That's quite a shift in fortune for a sector that relies on consumer purchases, whether for apparel, autos, homes, or other goods that aren't categorized as necessary staples.

Upscale Retail Stocks Up

During the downturn, discount chains such as Wal-Mart (WMT) and Family Dollar Stores (FDO) held their own. But discretionary stocks, especially higher-end retailers, were pummeled. In 2008, for example, Nordstrom (JWN) shares dropped 64%, Macy's (M) fell 59%, JC Penney (JCP) lost 55%, and shares of Internet retailer (AMZN) fell 46%.

All four have bounced back strongly since early March. Nick Kalivas of MF Global (MF) cites some reasons for the rally in consumer discretionary stocks: Despite job losses, a drop in gas prices has given consumers more spending money. Investors have been reluctant to bet against the federal government's stimulus plan, which could "have a positive effect on spending at the margin." Moreover, Kalivas says, retailers and other companies have done a good job of cutting costs and managing inventories.

Unlike the financial sector, "where management seemed to be caught off-guard [by the downturn], it seems as if [consumer discretionary companies] been able to navigate it well," he says.

Looks Like the Bottom

No doubt these factors played a role, but the biggest driver of consumer discretionary stocks has been the economy, many market experts say. "Even if we're still in a recession, the bottom has been reached and now we're turning up," says independent market strategist Doug Peta, who cites the release almost every day of "better-than-expected economic data points."

Consumer discretionary is typically an "early cyclical sector," meaning it's one of the first sectors to move when the economic conditions look ready to change, Peta says.

"Retail stocks are a bit of a leader of the overall market because they're very sensitive to the economy," Kalivas says. (Many retail chains reported April sales gains on May 7.)

Consumer Still in a Tough Spot

So investors are looking ahead, buying consumer stocks on the bet that an economic recovery is in the cards. The Reuters/University of Michigan Consumer Survey bolstered that case on May 1, when it showed consumer confidence rose in April. The confidence reading was 65.1 in April, compared to 57.3 the previous month and even higher than the 62.6 reading in April 2008. "Sentiment has improved," says Michael Church, president of Addison Capital Management. "People are starting to recognize that it's not the end of the world."

But it's a long way from "not the end of the world" to a true, strong recovery in consumer spending or the economy as a whole. That leaves many investors wondering whether, after such a solid rally, consumer discretionary stocks might have gotten ahead of themselves. "Certain areas of retail [might] still have further to run," Church says. But, "the consumer is still in a rough spot." Therefore, these days, consumer discretionary stocks are "at the top of the list" of the stock market's most vulnerable sectors, Church says.

William Rutherford, president of Rutherford Investment Management, says companies still have to prove they deserve the massive jumps in their stock prices. "Sooner or later, the companies are going to have to match the performance of their stocks," he says.

Hard for Consumer Outfits to Impress

They will have a chance to do so in coming weeks, when several retailers report quarterly earnings. Macy's reports results on May 13, followed by Kohl's (KSS) on May 14, Abercrombie & Fitch (ANF) on May 15, and Target (TGT) on May 20.

Other longer-term trends that could drive the sector's performance include the state of the housing and labor markets. In a recovery, "home sales tend to lead retail sales," Kalivas says. So, investors are hoping for more signs the dismal housing market could be hitting bottom. Homebuilders are also included in the consumer discretionary sector.

But, for Peta, employment is "the big driver." If job losses slow in future months, "that would suggest that perhaps we are turning a corner here," he says. The concern is that the consumer discretionary sector's current stock prices already assume the economy has taken a turn for the better. If so, it could be increasingly difficult for consumer firms to continue to impress the market.

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