Gavekal Capital: Internet Retail Portends Weakness in US Consumer DIscretionary

Tuesday, November 11, 2014

Internet Retail Portends Weakness in US Consumer DIscretionary

Consumer discretionary stocks have been by far the best forming cyclical sector of the US stock market for five years now. In the charts below, we show the relative performance of North American consumer discretionary compared to the MSCI World index and the MSCI North America index.

This huge outperformance makes perfect sense given the interest rate backdrop. Consumer discretionary stocks tend to outperform when short rates are falling and underperform when short rates are rising. In the chart below, we compare the relative performance of North America consumer discretionary stocks to 3 month US Treasury Bill yields. We invert the right axis to illustrate the negative relationship with rates. Short rates, leading by two years, have a 78% correlation with the relative performance of the consumer discretionary sector. Periods of relative underperformance in the consumer discretionary sector are marked by rising short rates (1985-1987, 1990-91, 1996, 1999-2000, 2007-2009)

So, if one believes that short rates are going to rise next year, as suggested by the Fed and the fed funds futures market, then consumer discretionary should be a source of funds in one's portfolio. Do we see any evidence investors are already rotating out of the consumer stocks? A good place to start in looking at any sector is the strongest group of stocks. When the strongest stocks in a sectors are powering ahead, it generally portends good things for the sector broadly. Conversely, when leaders begin to stumble, this often portends negative things for the sector.

Internet retail has been among the strongest sub-industries, with the average stock up 149% over the last four years, outperforming the MSCI World index by 81%. Internet retail is also the most expensive sub-industry within the consumer discretionary sector. In the table below, we show all the sub-industries within the consumer discretionary sector. At 6.4x sales, 40.7x cash flow and 68.4x earnings, the internet retail companies are by far the most expensive group of companies in the sector.

MSCI North America Consumer Discretionary Sub-industries

Focusing on a few of the companies in the internet retail industry, we see signs of distribution. After years of huge relative performance, Amazon, Trip Advisor and Priceline are tracing out big topping patterns and breaking down. This is not a good sign when the leaders of sector begin to roll over. The underperformance of internet retail portends weakness in the US consumer discretionary sector.

Relative Strength Point & Figure Charts Using Constant 2.5% Box Size & 3 Box Reversal

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