Consumer Discretionary Vs. Consumer Staples in 2016

Knowledge of stock market seasonal and sector cycles can improve investor performance dramatically. The key is to know when to be heavily or lightly invested, and whether to overweight consumer discretionary or consumer staple stocks. It is also helpful to know the stage of the business cycle, and where the Federal Reserve is positioned in tightening or loosening cycles.

Ned Davis Research, the Stock Trader's Almanac and others have found that the best time of year to be fully invested in stocks is from November to April, and the worst period is from May to October. This seasonal effect is pronounced, and a Ned Davis Research study found that, for the past 65 years, stocks have advanced by 8% in the best months compared to an increase of 1% in the worst months. This is where the Wall Street aphorism "sell in May and go away" originates. A consistent long-term application of this switch strategy results in a huge compounding advantage. For example, Ned Davis Research's study shows that a $10,000 investment in 1950 through 2000 resulted in a total gain of $585,000 for the best period in contrast to a total gain of $2,900 for the worst period.

Discretionary stock companies provide services and products that consumers find non-essential. This includes companies like Tiffany & Co., Amazon.com and the Walt Disney Company. Staple stocks involve products and services essential for day-to-day living. The Campbell Soup Company, Procter & Gamble and the Coca-Cola Company are good examples.

Market history clearly shows the best time of year to be fully invested, and the next step is to determine when to overweight exposure to consumer discretionary or consumer staples stock groups. Leuthold Group studied this question and found a definitive answer using the period October 1989 to April 2012. In November-April, the best seasonal period for equities, consumer discretionary stocks produced an excess total return of 3.2% vs. the S&P 500, while consumer staples stocks suffered a -1.93% excess return. During the worst seasonal period, May-October, consumer staples stocks showed an excess return of 3.5% and consumer discretionary an excess return of -2.5%. Leuthold Group demonstrates that this switching strategy is clearly superior to the simple "sell in May and go away" concept.

In January 2016, the historical numbers suggest that the switching model should overweight discretionary stocks for the next four months. However, there are other considerations based on the bearish behavior of the equity market over the last several weeks. Discretionary stocks carry a much higher-risk beta than staples, for example, and an investor must question whether the risk justifies an overweight position.

Consider where the economy is in terms of the business cycle as well. It is currently in the later stage of the cycle, and Martin Fridson, junk bond maven at Lehmann, Livian, Fridson Advisors, now sees the chance of recession in 2016 at 44% based on credit spreads. During economic downturns, defensive sectors like consumer staples perform better, and in bear markets, they tend to lose less than discretionary stocks. The Federal Reserve also started a tightening cycle in December 2015, and in early January 2016, that prodded Ned Davis Research to talk about upgrading consumer staples to overweight much earlier than usual. It maintains that it is too early to get overly defensive but investors should be on alert for that possibility.

In mid-January 2016, the consumer discretionary sector has lost 7% compared to a loss of 4% for consumer staples. This result is contrary to historical seasonal tendencies because the portfolio emphasis is now usually on discretionary stocks. If more favorable market action warrants going to a higher beta portfolio before May rolls in, then investors should go for it. That isn't the case at the moment, though, and caution is warranted. Defensive consumer staples look like a better bet here and will lose less if a confirmed bear market arrives in 2016.