What is Consumer Discretionary
Consumer discretionary is the term given to goods and services that are considered non-essential by consumers, but desirable if their available income is sufficient to purchase them. Consumer discretionary goods include durable goods, apparel, entertainment and leisure, and automobiles. The purchase of consumer discretionary goods is also influenced by the state of the economy, which can affect consumer confidence.
BREAKING DOWN Consumer Discretionary
In a poor economy, consumers are more likely to forego the purchase of consumer discretionary goods in favor of adding to their savings. The financial performance of companies that produce consumer discretionary goods is generally tied to the state of the economy as well. When measured as a sector of the economy, the performance of consumer discretionary companies can be an indicator of future economic conditions and stock market performance.
Consumer Discretionary as an Economic and Stock Market Predictor
In a weakening economy, consumer confidence typically declines, causing consumers to tighten their belts by postponing vacations and the purchases of non-essential products such as new clothes, televisions and new cars. The reduced demand for consumer discretionary goods is usually a precursor to lower sales for the companies that produce them, which can lead to worsening economic conditions and a recession. The stocks of consumer discretionary companies tend to lead a general stock market decline at the beginning of a recession.
Conversely, when the economy begins to strengthen and consumer confidence increases, the demand for consumer discretionary goods increases, boosting sales and stock performance of consumer discretionary companies. When signs of an economic recovery appear, consumer discretionary stocks usually lead a stock market recovery. Consumer discretionary stocks tend to outperform the stock market during strong economies, but they generally underperform in weak economies. Companies such as Target Corporation, The Home Depot, Inc., Walt Disney Company, and Amazon.com, Inc. are big holdings for mutual funds and exchange traded funds that focus on consumer discretionary stocks.
A distinction is made between consumer discretionary, also referred to as consumer cyclical, and consumer staples, which consumers consider to be essential products they need regardless of their financial condition or the state of the economy. Consumer staples include food, beverages, drugs, hygiene products and medical supplies. Consumer staple stocks, such as Johnson & Johnson, Procter & Gamble, and Coca-Cola tend to perform better than consumer discretionary stocks during weak economies, but lag them during strong economies. Consumer staple stocks are often held in portfolios as a defensive investment to counter the volatility of consumer discretionary stocks in a weak stock market.
Consumer Discretionary and Interest Rates
The consumer discretionary sector is highly sensitive to movements of interest rates. The early phase of an increasing environment for interest rates tends to bode well for the sector because it signals that the economy may be strong, unemployment may be down and consumers feel confident about spending money. Wage growth and increased lending also contribute positively to increased financial expenditures. For instance, as the U.S. economy gathered steam since the Great Recession of 2008, consumer discretionary stocks have posted positive returns. In the 10 years ended March 25, 2018, the consumer discretionary sector returned 224.82%, while the S&P 500 index gained 94.51%.