Retail Stocks Look Scary. What They Signal About Consumers.

it’s a scary time to be invested in consumer discretionary stocks. (David Paul Morris/Bloomberg)

Key Points

• The S&P 500 and Nasdaq Composite have seen significant gains, while consumer discretionary stocks have underperformed over the past month.
• Concerns about a softening labor market and potential reductions in real personal consumption are contributing to investor caution in the consumer discretionary sector.
• Despite some negative sentiment, analysts note healthy household balance sheets, stable consumer spending, and low household debt as a percentage of disposable income at 89.5%.

Jack-o-lanterns are just going up on porch stoops across the country, but the Christmas shopping season has already begun with sales this week at major retailers including Walmart , Amazon.com , and Target.

Despite all the signs of holiday preparation, it’s a scary time to be invested in consumer discretionary stocks, which have been left out of the market party.

The S&P 500 and the Nasdaq Composite notched record closes again this week. Over the past month, the former has climbed nearly 3%, while the latter is up more than 4.5%.

Meanwhile, the Consumer Discretionary Select Sector SPDR Fund is about flat over the past month, while the SPDR S&P Retail ETF has tumbled more than 5%.

A big part of the problem is the labor market.

“Employment growth is potentially below a level that keeps the unemployment rate flat,” wrote 22V Research’s Dennis DeBusschere in a note Friday. “The higher the unemployment rate goes (if that happens), the greater the downside risks to spending. In short, investors seem worried about the POTENTIAL for a sharp reduction in real personal consumption, helping explain the sharp declines in Retail (XRT) and S&P 1500 Discretionary.”

Technicals haven’t been helping either. As Fundstrat Head of Technical Strategy Mark Newton noted earlier this week, the sector fell under its late September highs—a negative technical indicator for the near term—leading him to believe that if there is a bounce, it will probably only come after additional weakness.

It is also possible consumer discretionary peaked in early September and is now beginning a correction.

“[T]he severity of its recent underperformance is worth monitoring in the weeks to come in the event that this sector cannot stabilize and rally,” Newton wrote. “While I remain technically Overweight ‘Discretionary’ a failure to rally back in the weeks to come would warrant a possible downgrade to Neutral, technically.”

DeBusschere was more cautiously optimistic, writing he thinks there will be an opportunity to go long on retail and discretionary names, but will need more data before making that call.

“The Discretionary sector has low earnings expectations, and corporate sentiment is weak. That is the bad news. The good news, the bar is low for earnings season, and if the macro data remains firm, that could create a buying opportunity in the group,” DeBusschere wrote.

Raymond James Institutional Equity Strategist Tavis McCourt thinks there is more hope for consumer discretionary. He noted Tuesday that although the job market is softening, job growth has been more affected by deportations than economic weakness, to the point that “it’s hardly worth mentioning.”

More to the point, he noted overall consumer spending and personal income growth look normal, and within a typical range. And total household debt as a percentage of disposable income stands at 89.5%, “which is as low as the U.S. consumer has experienced since the mid-1990s.”

“In sum, in aggregate, the household balance sheet is as healthy as it has been in over a generation,” he wrote.

Moreover, household debt continues to trend lower, and although liquidity has come down from its pandemic highs, it is still above prepandemic levels and has been climbing this year.

Overall that means aggregate consumer balance sheets are healthy, as are those of most individuals other than those very low on the income scale. And if most consumers only really pull back when their incomes are under threat, there is more good news in that “there is no story of a sudden slowing in wage growth across any cohort.”

Capital Economics North America economist Alexandra Brown was similarly upbeat. She noted consumer sentiment edged down to a five-month low of 55.0 in October, from 55.1, due to worries about inflation, the labor market, and government shutdown.

“Despite this gloom, we continue to expect actual consumer spending growth in the fourth-quarter to ease but remain fairly healthy,” she writes.

Of course the real test will come with the holiday shopping season, the most crucial time of the year for retailers, and their stocks. In other words if December is jolly, discretionary stocks won’t stay spooked.

Write to Teresa Rivas at teresa.rivas@barrons.com