Analysis: Underappreciated consumer stars in S&P 500 rally

Investors who had bet on the American consumer even as the U.S. economy was entering the Great Recession are the biggest winners as the S&P 500 stock index set a new closing record on Thursday.

Millions of jobs were lost in 2008 and 2009, the toughest recession in half a century, and many Americans saw the value of their investments and their homes dive. The U.S. consumer retrenched, focused on paying down debt.

And yet, the two strongest equity sectors that have fueled the S&P 500's recovery are consumer staples and consumer discretionary stocks, supported by strong earnings growth among names like Amazon.com Inc and Estee Lauder .

Since the benchmark index hit its previous closing high in October 2007, the consumer discretionary sector has gained 40.4 percent, while staples are up 41.3 percent. They have outperformed other sectors such as technology, while financials have been the worst, down 49.1 percent.

The benchmark closed at 1,569.19 on Thursday, overtaking the previous record of 1,565.15 set October 9, 2007. With the S&P 500 up just over 10 percent through the first quarter of 2013, prospects bode well for the market to at least hold these gains, if not push higher, as the U.S. central bank is expected to maintain its stimulus plan for now.

"The Federal Reserve's policies have been the primary catalyst to this rally," said David Joy, chief market strategist at Ameriprise Financial in Boston, where he helps oversee $675 billion in assets under management.

"What the Fed does and says in the months ahead will be the primary determinant of what stock prices do."

Discretionary and staples have posted 14 straight quarters of earnings growth, the longest streak among the 10 S&P 500 sectors. Eight of the 20 best-performing stocks since the 2007 highs are consumer discretionary companies, including Amazon, Netflix Inc and Priceline.com Inc .

Recent data shows the U.S. consumer, despite higher taxes and gasoline prices, continues to support the recovery. Retail sales rose at their fastest rate in five months in February and the U.S. unemployment rate, at 7.7 percent, is at four-year lows.

The government stimulus program passed in 2009 was in part responsible, as it slowed the rate of economic contraction during a rough time for the economy.

"It's easy to argue whether or not (the stimulus) was good for the economy, but numbers are showing it helped consumer spending," said to Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin.

DIVIDENDS SAVE THE DAY

As a whole, the S&P is paying more in dividends now than in the last quarter of 2007. More than 400 issues in the S&P 500 pay dividends, the highest since 1998, and the S&P's dividend yield is currently 2.45 percent, compared with 1.89 percent in the fourth quarter of 2007.

With the Fed forcing rates lower through its monetary stimulus, investors had to move elsewhere for yield. The attractive dividend yield in stocks, such as consumer staples, have brought in older investors, said Jeff Rubin, market strategist at Birinyi Associates in Westport, Connecticut. The current dividend yield in consumer staples is 2.75 percent, according to S&P.

"It has to do with the changing dynamic of who has the money," he said. "Baby boomers are retiring with trillions of dollars in assets they need to live off of. The historical asset of choice has been bonds, but at 1.8 percent on a 10-year note that's not going to get them the income they need."

The consumer staples sector has posted a total return of more than 60 percent going back to the 2007 high, thanks to reinvested dividends, while the consumer discretionary group follows with more than 53 percent. In fact, just one S&P sector - financials - is in the red compared to the 2007 highs on a total return basis.

One reason the consumer discretionary names may have done well is because that sector's downturn started earlier than the rest of the market. Earnings growth turned negative for the sector in the fourth quarter of 2006 and by the time the discretionary stocks hit bottom in March 2009, their forward price-to-earnings ratio was above 20.

That forward P/E peaked above 27 on April 2009. Despite the sector's rise since, the P/E is now just above 16, owing to the exponential growth in earnings. That's higher than most sectors, but below the 17 level where it stood at the 2007 peak.

Earnings growth among discretionaries is expected to continue, with fourth quarter 2012 growth estimated at 7.9 percent compared to an overall 1.5 percent expected earnings growth on the S&P 500 according to Reuters data.

A MORE BALANCED MARKET

Financials made up more than 20 percent of the index in October 2007, due in part to record-breaking profits from companies like Lehman Brothers and Bear Stearns, which no longer exist. Financials now make up 15.9 percent of the index.

At the top of the internet bubble in 2000, the information technology sector accounted for roughly 35 percent of the S&P. Tech is still the largest sector, but at 18.2 percent.

David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates in Toronto, said the new S&P record could bring more investors into equities.

"It could be that you get a wave of buying from frustrated people who have been watching their savings erode in real terms," he said. "Watching headlines about the market hitting a new high could be a catalyst of frustration that pushes people off the sidelines."

There are concerns, however. The U.S. stock market has diverged substantially from credit spreads, U.S. and European government bonds and emerging markets stocks, notes Marko Kolanovic, global head of derivative and quantitative strategies at JPMorgan Securities.

That suggests the S&P 500 "might be underestimating global risks, and hence could be prone to reversion, i.e. underperformance in relative or absolute terms," he wrote in a note on Thursday.

Mike O'Rourke, chief market strategist at JonesTrading in New York, said that more than 65 percent of speculator positions in the futures market are long positions - a sign that many are bullish right now.

The mild pullback in the S&P prior to Thursday's gains, triggered by worries about a bailout in Cyprus, helped even out technical indicators that were showing the market's run was overextended. The short-term relative strength index, which touched the 70 level that indicates an overbought condition as of mid-March, has retreated considerably.

Many market participants expect the market to pull back after hitting a new high, which would make the technical indicators even stronger.

(Reporting by Rodrigo Campos and Herb Lash; Editing by David Gaffen, Tiffany Wu and Tim Dobbyn)