Equity Sector Update: Reiterate Consumer Discretionary Underweight

Summary

• The consumer discretionary sector remains about 15% overvalued based on the current earnings outlook. We reiterate our underweight recommendation.
• The S&P 500 index is now about fair value, again based on projected earnings. If, as we expect, forward earnings are revised downward, equities will follow.

Market Implications

• We expect equities to trade in a volatile range and trend downward as earnings outlooks are revised downward.

Consumer Discretionary

Since the beginning of April, the S&P 500 consumer discretionary sector is down 18% and has underperformed the SPX by 11.3%. During that time, it has gone from being 50% to 20% overvalued based on forward earnings.

We see continued downside for this sector on an absolute basis and relative to SPX.

The one cautionary note is that two companies account for 46% of the market cap of the index – Amazon (AMZN) at 28% and Tesla (TSLA) at 18%. Their valuations are driven as much by sentiment as economic fundamentals, and any position in the consumer discretionary sector is as much a view about these companies as the overall sector.

Investors can hold the consumer discretionary sector via the XLY ETF.

Homebuilders (Again)

April saw unexpectedly weak new home sales at 591,000 vs 749,000 expected, ‑16.6% MoM. This knocked homebuilder XHB ETF down 2.6%, slightly worse than the overall Consumer Discretionary sector (down 2.2%).

Indeed, homebuilders are among the better performers in the consumer discretionary sector. PulteGroup (PHM) is down 2%; Lennar (LEN) is down 10% and DH Horton (DHI) is down 12%, versus 18% for the sector.

The important point is that unlike previous cycles when homebuilders went into downturns with large overbuilt inventories, this time there is a significant housing shortage in the US. Homebuilders have bulging backlogs, not bulging inventories. They can continue to build through a downturn and still make money.

We acknowledge that the market will fall back on conventional wisdom about homebuilders until they produce these results.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.