2023-05-16 13:13:20 ET
Summary
- In recent months, retailers have given dismal market returns, and new data reveals a decline in card spending, while retail inventories continue to make new highs.
- Despite surpassing sales and EPS projections in Q1, the sector's golden hour is unlikely to last as savings and credit card delinquencies mean-revert.
- With interest rate hikes expected to have an impact on economic growth, the short thesis remains appealing.
Investment Thesis
In my previous article on the VanEck Retail ETF (RTH), I put forward my short thesis on the consumer discretionary sector. The consumer discretionary sector has delivered poor market returns in recent months and fresh data shows a sharp deterioration in card spending for retail and food services. Despite exceeding estimates for sales and EPS numbers during Q1, the golden age for the sector is unlikely to continue as savings and credit card delinquencies mean-revert. The short thesis remains attractive with interest rate hikes predicted to impact economic growth. RTH, which is down less than a percentage point over the last three months, remains a good short candidate for the next 6-12 months.
A Review Of My Previous Article On RTH
RTH has been in my opinion extremely resilient since my previous article on this ETF back in January 2023. Assuming no cost of funding, the fund is down less than a percentage point over the last three months and has rallied by more than 7 percentage points since the March 10th bottom. Adding funding costs in an environment with spot rates at over 5%, an investor would probably be down 1.5-2.5%. Despite the fact that shorting RTH was a profitable trade for most of the last three months, I believe that the bear thesis for shorts is yet to come rather than passed.
Regarding the relative performance of this sector versus the market, consumer discretionary stocks have delivered poor market returns, in line with my framework that we are still in a bear market. Unlike the beginning of previous bull markets where the consumer discretionary sector was leading the pack, we're now seeing the opposite playing out.
Recent Developments
With earnings season now coming to an end, we're able to get a good glimpse into the performance of consumer discretionary stocks. Remarkably, both sales and EPS numbers have exceeded my estimates, driven by a very resilient labor market. In fact, consumer discretionary has shown one of the highest rates of both EPS and Sales growth in the S&P 500. Similar results can be observed for the Nasdaq 100 index.
Of course, this is a cyclical sector, which means that investors will generally be better off selling when things are good and buying when there is "blood on the street". We are definitely not in a "blood on the street" type of moment, with markets holding up remarkably well despite record-high interest rates and the stress that we've experienced in the banking sector.
Another indicator I'm paying attention to is the price action that we've seen following recent earnings results. While the sector is now trading at a higher level compared to the March lows, I didn't see much strength in consumer discretionary stocks, and with earnings season now behind us, I believe there is no clear catalyst that will take this sector higher in the near future.
Bloomberg - Results for S&P 500
Also, I think it's important to put these earnings into a wider macro context. From a record-low credit card delinquency rate to a record-high stack of excess savings from the economic response to the COVID-19 crisis, this has truly been a golden age for the consumer discretionary sector. Thinking probabilistically here, I would assign very low odds of this situation continuing, while I see a very decent chance of both savings and delinquencies mean-reverting. On that note, we can already see that credit card delinquency rates are now on the rise for 3 quarters in a row, although coming from a very low starting point.
I believe we're starting to see some cracks in consumer discretionary spending. As illustrated by recent data showing the change in card spending for retail and food services, we've noticed a sharp deterioration after March 2023, and spending is now lower than in 2021 and 2022. This is corroborated by credit card proprietary data from both Bank of America and Citi for the months of March and April 2023.
Sophia Knowledge
Where To Go From Here
I believe the short thesis remains particularly attractive in this market environment. We have not yet seen real pain in financial markets over the last two years and the best reflection of this in my opinion is the S&P 500 which trades at 12% below its all-time high while implied volatility remains low, even by historical standards. Moreover, many indices across the world like the CAC40 are at an all-time high or close to record levels.
I think that consumer discretionary stocks are poised to see more pain ahead once interest rate hikes start impacting economic growth. On this topic, it's interesting to see that retail inventories are now at an all-time high which comes at a moment in time when consumer spending is about to normalize. This has never ended well in previous cycles.
Sophia Knowledge
Regarding inflation, it is pretty clear by now that it has boosted nominal sales and EPS growth for many consumer discretionary names over the last 18 months. However, we are now past peak inflation (at least in the short term) and the trend in recent months has been lower and lower, which will start impacting nominal growth levels going forward. All in all, I think that RTH remains a good short candidate over the next 6-12 months.
Shorting RTH
Given the very low levels of implied volatility at the moment, I have a preference for using options to short RTH. I believe that put spreads offer a good risk-reward at the moment. Shorting a stock using long put spreads is a strategy that involves buying put options while simultaneously selling put options at a lower strike price. I personally like the 10% and 20% out-of-the-money strikes.
Key Takeaways
In recent months, the consumer discretionary sector has given dismal market returns, and new data reveals a significant decline in card spending, while retail inventories continue to make new highs. Despite surpassing sales and EPS projections in Q1, the sector's golden hour is unlikely to last as savings and credit card delinquencies mean-revert. With interest rate hikes expected to have an impact on economic growth, the short thesis remains appealing. RTH, which has fallen by less than a percentage point since my previous article, is still, in my opinion, a solid short candidate for the next 6-12 months.
For further details see:
RTH: Retailers - A Golden Age Coming To An End?