RCD - RCD ETF: The Wheels Are Coming Off

2023-05-21 08:41:28 ET

Summary

• RCD, an equally-weighted discretionary offering, has underperformed its cap-weighted counterpart over the long term and short term.
• Conditions in the industry don’t look comforting.
• High-beta plays could remain vulnerable in this environment.

“Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.” - James W. Frick

As the name suggests, the Invesco S&P 500 Equal Weight Consumer Discretionary ETF ( RCD ) is a financial product that gives you equal exposure to the consumer discretionary stocks that comprise the S&P 500. Over the years, it's been rather evident that the consumer discretionary ((CD)) space has typically served as a hotbed for conjuring up certain stock market darlings (Amazon, Tesla, etc.), with these stocks witnessing an exponential rise in their respective market caps. In that regard, the equally weighted RCD has paid the price and has significantly underperformed its counterpart - the Consumer Discretionary Select Sector SPDR ETF ( XLY ) since its inception.

Curiously enough, if you track fund flow sentiment over the last few months, you'd discover that the equally-weighted RCD has witnessed a drastic contraction in its AUM since mid-March, even as the cap-weighted CD play - XLY, witnessed much lower declines. As I’ve repeatedly been highlighting in my commentaries, it’s not just the CD sector, even if you look at the S&P 100, S&P 500, or the Nasdaq 100, and juxtapose those indices to their equally-weighted alternatives, it’s pretty evident that investors prefer to stay wedged with more mega and large-cap centric options during this period of broad uncertainty in the markets.

Then, it’s also not as though conditions in the CD sector are going smooth sailing. In a recent tweet, I’ve noted how the CD sector’s strength as a function of the S&P500 isn’t able to gain any traction for weeks, and this speaks to deteriorating conditions across the board.

Prominent retailer Home Depot (HD) recently raised a lot of red flags about consumer sentiment during its quarterly event. Followers of The Lead-Lag Report would note that I've been flagging the egregious charts of lumber prices and how this weighs on the economy. Well, Home Depot was quick to note that weakness with Lumber prices was hugely instrumental in the 4.5% sales decline witnessed in Q1. Worryingly, the company believes that comp sales could decline by 5% for the whole year.

If you want to move away from housing to another CD sector, you may consider looking at autos and how Tesla (TSLA) has been faring. In a Lead-Lag Live podcast episode with EV expert Gary Black, we’ve explored how this company, which likes to be perceived as a premium entity, has been forced to cut prices in order to meet volume targets for its Model 3 and Model Y units.

Then the overall trend in the retail sales numbers too don't fill me with a great deal of confidence. Sure, some may point to the +0.4% uptick in April, but it's worth noting that this was only half as much as what the street was expecting. Besides, before April in 4 out of the 5 months, retail sales were trending lower.

I believe there are a few reasons for this. Firstly, it's worth considering that the spending engine of an economy - the middle class - has been losing its clout over time. As noted in a tweet, the share of the middle class and their aggregate income has been on a declining trend.

Then data from the Bureau of Economic Analysis also shows that the personal savings rate in the US has plummeted well below the historical norm. Since 1959, the average annual savings rate was 8%, but lately, it has been trending around the 5% levels. For context, during the heights of the pandemic when the savings rate was over the 30% mark, it is believed that there were $2-$2.5 trillion of excess savings which likely could have been diverted to discretionary spending. That ammunition is no longer there.

What’s also quite worrying to note is that a large chunk of retail spending currently appears to be driven by record-high credit card debt and this continues to get financed at higher rates. The Fed's rate hiking cycle may not have many legs but it's worth considering that the impact of rate hikes are typically felt after a 12-month lag, which means you're still looking at an impact of 400bps of rate hikes that need to come through (considering that the Fed Funds Rate was just 0.75% a year ago).

Given that consumer spending in the US accounts for nearly two-thirds of GDP, it's no surprise to discover a downward revision in this year's Q3 and Q4 GDP growth rate numbers.

Conclusion

Even if you want to stay in denial and believe that underlying conditions in the consumer discretionary segment are just fine, I’d still urge you to ponder over whether it makes great sense to stay connected to a high-beta segment such as this (RCD’s 60-month beta is 1.38x ), particularly when the broader markets are at a risk of facing an accident soon enough.

Lest I be accused of undue bias, I’d also like to add that even Julius de Kempenaer, a renowned expert on gauging sentiment across various market sectors, recently came on the Lead-Lag Live Platform and noted that the CD sector was at risk of turning into a laggard.

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