Sagflation May Make Consumer Stocks A Minefield

The 2010 herd movement into consumer discretionary has produced strong movements in many stocks, as highlighted by the 25+% increase in the sector YTD. The sector now trades at a beefy 22x TTM earnings. I understand that this is a sector that has traditionally outperformed the market during periods of economic recovery but the market appears to expect great things in this segment. Another sector that has typically led the market during recoveries is financials, which has increased a more modest 5% YTD, highlighting the non-traditional nature of this recovery.

Under my sagflation theme, the next year likely exhibits increasing instability in prices and relatively modest real economic growth. The price instability may ultimately come out in rising CPI numbers, however I believe a more likely scenario is distinct bubbles in segments of the world economies as central banks continue activist policies and exert pressure on exchange markets. I would argue the rising inflation in China and Brazil are a couple proof points of this price instability. Within the U.S., the price instability has revolved around producer prices, with these price increases accelerating to 4-6% in 2010 after declining 2.6% in 2009.

My point in this post is that consumer discretionary is a minefield, in my view. As highlighted by the lower-than-expected guidance from Talbots, ticker TLB, fickle consumer tastes can take down a stock fairly quickly. I also believe consumers remain very price conscience. However, the real reason for my general skepticism about consumer discretionary, as a whole, is rising costs in cotton and potentially oil pressuring margins. So far I suspect companies have offset rising costs by substituting for lower quality materials and altering the mix of products marketed and emphasized in stores. A combination of rising interest rates on consumer debt (tamping down demand) and rising production costs (hurting margins) may ultimately prove the discretionary part of consumer discretionary.

A broader point, and one I expect to explore further in later posts, is that the current stock rally likely continues for a couple quarters but is based more on nominal growth than real growth.