Schwab sector views time to remove the staples charles schwab gas x tablets himalaya

Schwab Sector Views is our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is designed for investors looking for tactical ideas. We typically update our views every two weeks. ‘Tis the season…for staples!

With the traditional kick-off of summer upon us, consumers’ eyes will likely be turning toward the staples sector, whether they know it or not! No, we’re not talking about toilet paper and laundry detergent (although those are also necessary summertime staples) but hot dogs, ketchup, mustard, adult and non-adult beverages, sunscreen, mosquito repellant and many other staples items. But investors seem unimpressed with the long list of items produced by the sector, as the group has underperformed substantially over the past year and the past month.

The consumer staples sector has been a traditionally boring sector, largely plodding along—performance historically has tended to lag a bit when the economy is growing, but tended to improve on a relative basis when the economy slows down. Over the past year, the group has been the worst performer among the 11 S&P sectors, apparently weighed down by competition concerns combined with cost worries that could potentially shrink margins (the difference between selling prices and costs of goods sold). The elephant in the room

At first glance, it may seem an obvious story: The economy is growing and we’re in the midst of an overall bull market, so the traditionally defensive staples sector should be underperforming while the consumer discretionary sector typically may perform better during economic expansions. And in fact it has been doing just that.

But there’s an elephant in the room that consumers are well aware of: Amazon. Although the media often treats it as a technology company, Amazon is actually a member of the consumer discretionary sector. And when you look at the performance of the group compared with the performance of the overall market (in other words, relative performance), you can see below that there’s quite a bit of difference between discretionary performance with and without Amazon—compared to the performance of the staples group, which also doesn’t have Amazon.

So what does that mean for investors? First, nothing in this article should be construed as a recommendation one way or the other for investing in Amazon or any other company mentioned. But it also further illustrates the point that concern about competition, specifically from Amazon, is not only affecting the consumer staples sector, but the consumer environment as a whole—and we have been noting for some time that we believe that concern is overdone. There is little doubt that the internet has changed the game in the consumer environment, but we think those that believe “traditional” retailers and product producers are dead are overstating the issue. Consumers’ need for many items in the staples sector hasn’t changed, but the way they get them has. And while that has pressured margins, Yardeni Research reports that the 2018-2019 expected growth rate for revenue of the staples sector is in the middle of the sector pack, while earnings revisions for the group were higher for the first four months of this year than at any time since at least 1995 (on a forward earnings basis according to Thomson Reuters). And there is little doubt that the American consumer remains healthy, with confidence elevated, wages rising and unemployment low.

However, it’s not just the revenue side that is getting pressured, as costs also appear to be rising. In the most recent earnings reporting period, staples companies such as Kellogg, Coca-Cola and Mondelez have pointed to higher shipping costs. Meanwhile, the Labor Department has reported that trucking costs were roughly 6% higher in April versus a year ago—the fastest growth in close to seven years (CNNMoney, May 14, 2018). But these costs are also affecting Amazon, as they rely on trucks for much of their delivery business. This is where we may start to see, and in some place have already seen, some price increases to make up for the hit to the cost center. I’m sure you’ve noticed some of this already—prices for Amazon Prime are going up, and instead of raising prices in some cases, packages are containing less product—my usual seven hot dog pack still costs the same, but now contains only six hot dogs!

The point is that we believe the consumer staples sector has been dealing with tight margins for some time yet they have found a way to survive, and we have confidence that they’ll be able to do so again. Additional supports for the sector include better valuations—now below their five-year average and in line with the overall market (Yardeni); a rising dividend yield (FactSet); and, according to Ned Davis Research, high short interest relative to history, which indicates elevated negative sentiment, often a contrary indicator.

Don’t mistake this for a bullish outlook. Certainly the sector is facing some challenges, but as noted we think the bearishness of the past year is overdone. We continue to think investors should maintain a market weighting toward the group. Its defensive characteristics remain in place, and we think those will be increasingly valuable as the Fed continues to raise interest rates and overall stock market volatility remains elevated.