The Frugal Consumer

October 21, 2023 by Martin L. Yokosawa

During the Third quarter of 2023, the S&P 500 Index lost 3.6%, the NASDAQ Index lost 4.1%, the Russell 2000 Growth Index lost 7.5%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 5.2%.¹

The recent decline in the stock market coincided with normal seasonal trends and was arguably overdue given the historic run in the first half of 2023. A year-to-date analysis indicates a divergence in returns between big tech which largely benefitted from the nascent AI craze.

There are many concerning issues in the markets today, but according to the September retail sales number released on Tuesday, the 0.7% increase and retail sales core increase of 0.6% both beat the 0.3% increase analysts expected. In addition, data for August was revised higher to show sales advancing 0.8% instead of 0.6% as previously reported. These numbers are important since they give insight into consumer discretionary spending.

The key aspects of consumer discretionary are:

• Consumer discretionary is an economic sector classification of non-essential consumer goods and services.
• The sector, its industries, and individual companies are watched by analysts and investors as an indicator of economic growth or slowdown.
• Consumers tend to spend more on consumer discretionary products in economic growth phases, when they may have more disposable income.
• Spending on consumer discretionary products slows in a weak economy.
• Consumer discretionary can be contrasted with consumer staples, which is a sector composed of industries/companies that produce products essential to daily needs.

As a general statement, if the consumer is spending, those funds will grease the wheels of the overall economy and be reflected in market pricing. This is where things become tricky since markets typically reflect future prices which are derived from future expectations and the probability that they will occur. The probability component is the risk portion of the equation. 

In the case of the strong retail sales figures and blow-out increase in payrolls reported last week, many would think everything is good and prices should go up. If it were that easy, I would not be here serving and writing to you. The immediate direction of prices reflects a change in expectations about the future. Many times, good news is bad for market prices and vice versa. A good retail sales or payroll figure can be taken as a negative since the Federal Reserve may decide it is too inflationary and that they will more strongly consider raising interest rates to slow down an expansion.

There are numerous scenarios with varying magnitudes of importance and size playing out each day. Traders attempt to exploit these expectation changes by taking short-term positions while as a long-term investor, I monitor changes in expectations and use them as pieces of an ever-changing investment puzzle to provide clarity about the opportunity and risks in the market.

U.S. stocks typically post their best returns in the fourth quarter. Since recent strong economic numbers have not seemed to sway the Fed’s mood about interest rates in a material way, coupled with the fact that the geopolitical unrest has not severely impacted global markets are signs that a trapdoor market drop may not be present.

Another market positive is that the first half gains driven by a select few big-tech companies dominating the S&P 500 have started to broaden; this is a healthy sign for the market and a good environment for stock picking. 

There are, as always, items which should be followed as early warning signs of a market correction.

I am watching:

1. The inversion of the 2 yr. U.S. Treasury yield to the 10 yr. yield and how it unwinds. The inversion of the yield curve is many times a precursor to a recession.
2. The health of the banking system and its ability to provide liquidity to businesses.
3. The health of the consumer due to the increase in credit card balances.
4. Geopolitical unrest.

Currently, none of these factors are at a breaking point, but I am watching them closely in relation to how the market is pricing these risks. Barring a Black Swan event in the fourth quarter, I believe the economy should be able to recognize the new sustained higher interest rate environment and adjust to it.

Due to elevated valuations, the big tech names which did well in the early part of the year are losing some of their luster and investors are migrating to new areas of interest. There are signs that value-oriented names without excessive debt are being looked at favorably.

During the quarter, I will continue to review our existing investments and search for new opportunities which exhibit current positive attributes and prospects for future success.

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1. These returns are price based and exclusive of dividend reinvestment. ↩︎