In this guest commentary, Julian Howard, investment director at GAM, the Zurich-listed investment house, says that while there might be concerns that US consumer stocks could be knocked down, there are consumer sectors well worth attention.

The US third-quarter reporting season is almost over – and with equity markets in the US having had a strong run since the financial crisis, there is understandable nervousness of what happens if any earnings news suggest valuations aren’t justified at around current levels. Into this sort of argument steps Julian Howard, investment director for GAM, the international investment house. He focuses his attention on issues of consumer spending and the associated consumer-related sectors of the US economy. As ever, the editors here are pleased to share these comments with readers and invite responses; they do not necessarily endorse all the views expressed from guest contributors.

The US consumer is far from dead, but they’re certainly not spending enough overall to justify the elevated valuations of consumer sector stocks. So is the market pricing in a return to pre-crisis levels of consumption? And if so, are consumer stocks in danger of a harsh reality check?

The answer lies partly in history. Consumption, which accounts for about three quarters of all US economic activity, really took off when Americans modernised their lifestyles following the Great Depression and the World War II, purchasing millions of refrigerators and cars.

In more recent times, the Clinton boom years and the post-Iraq war credit surge re-confirmed the primacy of this aspect of economic activity, with retail sales growing at an incredible 11 per cent annual rate at one point in early 1994. These were exceptionally strong periods for consumption, bringing with them symbolic phenomena like the three-car garage and restaurant-grade stoves to the homes of ordinary Americans.

But the warning signs were there both for consumers and investors. Income distribution as measured by the Gini coefficient had been steadily deteriorating in America. Only credit allowed many to paper over the cracks of their falling relative incomes.  And the stock market never really bought into the consumption frenzy, with consumer stocks trailing the broader market by more than 40 per cent from 1992 to the end of 2007.

The crisis of 2008 saw a huge unwind in consumption as households retrenched and attempted to deal with their engorged balance sheets. Cutting back spending amid heightened uncertainty was a perfectly rational choice, one that proved to be not just a short-term expedient for Americans worried about the future but arguably a shift in attitude to consumption that persists today.

Surveys suggest that the emerging “millennial” demographic (born since 1982) tends to prize experiences over material possessions. Combined with the fact that they are earning comparatively less than their elders and remain saddled with college debt, it seems that an entire emerging cohort won’t be consuming in the manner expected.

Regardless, the S&P 500 consumer discretionary stocks began to re-rate from 2012, outpacing their associated earnings. After the market turmoil in August, valuations have come down somewhat, though a move in the price-to-earnings ratio from 22.6 at the end of July to 22.1 on 26 October does not make the sector outright cheap.

A more significant correction might be required for the sector as a whole to look reasonable in an environment of low single-digit annual retail sales growth and personal consumption expenditure.

Still, retailing has seen incredible innovation in recent years, with some stocks rightly enjoying high valuations in the expectation that they will capture market share from their peers by transforming the nature of spending itself. Internet- and other technology-driven retail names particularly come to mind.

But for those anticipating a resumption of pre-crisis rates of consumption, it may be appropriate to reassess the time horizon in which this is likely to materialise and, for that matter, whether such a resumption is likely or desirable. Rather than an outright correction the market could simply be adjusting to the new dynamic by rewarding those stocks which can build market share, for instance through innovation, while punishing those that lose it.

Secular trends provide further investment opportunities. One example is cars, where sales in the first half of 2015 were the best for a decade as Americans replace the fleet that’s been steadily ageing since 2002. Another is homebuilding stocks. For all that has been written about young people being less materialistic, it is reasonable to assume that they cannot live in their parents’ basements forever and that new household formation would be the logical outcome of finding a partner and perhaps starting a family.
Surely a consumer sector that prizes selectivity over credit- and volume-driven gains is both more sustainable and conducive to insightful investment ideas.