Your mother was right: there are needs and there are wants. If your childhood was like mine your mother seemed to only have money for needs, but from time to time she was able to find some money for wants. Every consumer has to determine when they have money for needs and when they have money for wants and investors are well aware of this tendency. This is why it's important to track what consumers are buying and when. There are various factors that allow consumers to focus on their wants and not just their needs, but investors must remember that needs are always on the shopping list. This article will help investors to know what to look for in the markets to anticipate consumer behavior and how it will help them determine when to shift assets or exit the markets.

Needs vs. Wants
The fatal words ring in the ears of almost every child, "No, put it back you don't NEED that." If mom was lecturing you on what you do need she would likely list items like food, milk, cleaning supplies, doctor's appointments and so on. These things aren't very high on any child's list of perceived needs and they will likely list cookies, candy, toys, etc. as what they perceive as "needs." As adults we are constantly deciding between what we can spend and what we should spend.

Watching the monthly consumer sentiment reports will help investors get an idea of what consumers are thinking about the economy. If consumer sentiment is falling, it is likely that shoppers will focus on needs and not wants. If consumer sentiment is rising then it's more likely that shoppers will be willing to purchase items they don't necessarily need like handbags, cars or even new homes. (For further reading, check out Using Consumer Spending As A Market Indicator.)

Nondiscretionary vs. Discretionary
Needs and wants have different names in the financial markets. Needs are known as nondiscretionary or staples while wants are known as discretionary or cyclical items. The nondiscretionary or staple items are simply our needs, in other words, goods and services that are must haves. These are items that consumers must purchase no matter what the market is doing. It's common to hear analysts describe stocks that specialize in staples as things we "eat, drink and smoke." However, staples aren't really limited to these products because healthcare and pharmaceuticals are also products and services that are needed, even in a recession.

Discretionary or cyclical items are products like clothes, tools, entertainment, furniture, jewelry recreational products, houses, etc. Stocks that focus in these kinds of items tend to do well when the economy is in an expansion phase of its cycle. During the expansion of an economic cycle both the staple and cyclical stocks will rise, but cyclical stocks will normally rise at faster pace. Cyclical stocks do well during the beginning of the expansion because interest rates are normally very low and credit is easier to come by. This phenomenon is by design because the Federal Reserve is attempting to entice consumer to shop for their wants with lower borrowing rates. As the economy continues to expand, unemployment will usually drop, putting more consumers back in the malls and allowing demand for discretionary items to rise. (To read more about investing in cyclical stocks, read The Ups And Downs Of Investing In Cyclical Stocks.)

The latter end of the economic cycle is commonly accompanied with a weaker dollar as the cost of commodities, goods and services continue to rise. Eventually the consumer dollar is being stretched further and further to the point that shoppers are unable to purchase discretionary items with the same frequency and must direct their attentions to their primary needs. This results in investment dollars being moved from the cyclical stocks to the staple stocks. To combat the inflation the Fed will commonly raise interest rates, which will take many bond investors out of the fixed income markets and into higher dividend paying stocks. One common characteristic of consumer staple stocks is that they tend to also pay higher consistent dividends, which is another reason why consumer staple stocks tend to perform well when the economy begins to turn south.

Relative Strength
Both consumer cyclical and consumer staple stocks will commonly rise during bull markets, and cyclical stocks will tend to outperform. This goes back to the market mantra of "a rising tide lifts all boats," which is to say that most stocks will rise in a bull market. The reverse is also true: a falling tide will lower all boats, so during a bear market you will likely see even the staple stocks drop, but just not at the same rate as cyclical stocks. Also the continued dividends paid by the staple stocks will help to soften the blow because money is being paid out to the stockholder. Since the demand for staple goods is fairly inelastic, those goods will continuously be purchased.

Figure 1 compares the exchange-traded funds of the Spyders Consumer Discretionary (XLY) fund to the Spyders Consumer Staples (XLP) fund using a relative strength line. This line compares the price of the XLY to the price of the XLP using a 1:1 ratio. In this case XLY is the numerator, which means if the line is uptrending then discretionary stocks are outperforming the staples. The XLP is the denominator, and a downtrending line indicates that the staples stocks are outperforming. It's important to note that this line doesn't guarantee an uptrend or a downtrend in the price of the fund; it only tells investors which ETF has the highest strength in relation to the two funds.

Figure 1: Relative Strength of XLY and XLP
Source: ProphetCharts

Sage of Shopping Stocks
The relative strength chart of the XLY and the XLP can actually be used to help investors determine market tops and bottoms. Drawing trendlines on the relative strength line as in Figure 2 will act as an indicator of when investors are turning their focus from the cyclical stocks to the staple stocks. Remember, if the relative strength line is downtrending then consumer staples are outperforming and the markets are turning bearish. When the trendline is broken and the relative strength line moves higher, then the markets will likely turn bullish and consumer cyclical stocks will be the leaders. Of course, a break of the uptrending trendline would indicate that the market is about to turn bearish again.

Compare the turns in the relative strength line to the swings in the S&P 500 to see how well the relative strength of the XLY/XLP predicts market changes. Investors using this tool may choose to allocate money back and forth from cyclical stocks back to staple stock and vice versa when trendlines break or they may choose to exit the markets and go to cash on the bearish signals. (Learn a stop-loss strategy that will help you protect your gains when trading breaks in Trade Broken Trendlines Without Going Broke.)

Figure 2: Relative Strength trendline and S&P 500
Source: ProphetCharts

The Bottom Line
The consumer is a major driving force behind the economy, which is why their behavior is so important to investors. Knowing where consumers are putting their money is an important factor to choosing profitable stocks, but can also help investors determine when to reallocate their assets or exit the markets altogether. While investors may always want to be in stocks, they need to know when to make their exits. The staple/cyclical stocks relative strength line can help an investor make that choice - even without his mother's permission.

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