Growth Returns: These Cyclicals Deserve Attention

While there’s no guarantee Washington won’t try to thwart economic growth again in 2014, the growing consensus is that if Congress keeps its distance, the economy is ready to accelerate.

As reported at Calculated Risk, Merrill Lynch is making a case that the economy “exits rehab and starts growing at a 3%” next year. And it’s not as if we need to hold our breath that more things go right to get us to that level of growth. As the Merrill Lynch forecasters noted we would have been at 3% to 3.5% this year “absent the shocks out of Washington.”

While Merrill concedes that the “cyclical bounce” that comes with economic expansion has already begun to play out, it’s not a ninth inning situation. That’s echoed in a recent research note from Mark Lushini , chief investment strategist at Janney Capital Management. He notes that virtually all of third quarter earnings growth for the S&P 500 was delivered by the cyclical sectors, led by a 20% year over year gain for Consumer Discretionary. He expects the cyclical leadership to be sustainable, in part based on recent data from the ISM Purchasing Managers Index:

US Purchasing Managers Index Chart

US Purchasing Managers Index data by YCharts

“The level of the ISM Manufacturing PMI (and its direction) has historically led directional changes in S&P 500 EPS growth. And given the recent surge in global PMIs (and the best U.S. level since April 2011), this would appear to imply S&P 500 profit growth should similarly accelerate.”

Indeed, according to S&P Capital IQ, 2014 operating earnings per share for the consumer discretionary sector of the S&P 500 are expected to advance nearly 17%, compared to 10% for the overall 500. The sector’s 2013 estimated growth is near 13%.

That sort of growth doesn’t come cheap. The sector’s 17.8 PE ratio for 2014 is well above the 14.9x forecast for the entire S&P 500. But given the strong forecasted earnings growth it’s worth noting that 17.8 would actually be lower than the sector’s estimated 2013 PE ratio of 20.7.

The two largest ETFs, Consumer Discretionary Select SPDR (XLY) and Vanguard Consumer Discretionary (VCR) had identical top-five holdings: Amazon (AMZN), Comcast (CMCSA) Walt Disney (DIS) Home Depot (HD) and McDonald’s (MCD). Leaving Amazon, and its whacky-valuation out of the conversation, Disney and McDonald’s emerge as two compelling stocks with below-average forward PE ratios:

CMCSA PE Ratio (Forward 1y) Chart

CMCSA PE Ratio (Forward 1y) data by YCharts

In terms of revenue and earnings growth, Disney has had a better time of it lately:

DIS EPS Diluted (TTM) Chart

DIS EPS Diluted (TTM) data by YCharts

But for income investors, McDonald’s is a much better option; its 3%+ dividend yield is two points ahead of Disney’s payout. Moreover, McDonald’s has a long record of consistent and strong dividend growth, which is nice recompense to wait for revenue growth to pick up. If these stocks interest you, unleash some financial advisor tools on them.

While plenty of U.S. based consumer discretionary stocks give you emerging markets exposure -- McDonald’s being exhibit A with nearly 30% of sales in developing economies -- if you want a more direct line to the burgeoning middle class consumer in those markets another option is the iShares MSCI Emerging Markets Consumer Discretionary etf (EMDI). As seen in this chart, splicing out consumer spending from the more broad-based iShares MSCI Emerging Markets ETF (EEM) has worked well this year, as the diversified emerging markets portfolio has been weighed down with commodity-related holdings that don’t show up in a consumer-spending portfolio.

EMDI Total Return Price Chart

EMDI Total Return Price data by YCharts

A word of caution, the iShares MSCI Emerging Market Consumer Discretionary ETF is not going to be the most liquid of ETFs, with less than $10 million in assets. Moreover, it’s heavily weighted in auto manufacturers and suppliers.

Carla Fried, a senior contributing editor at, has covered investing for more than 25 years. Her work appears in The New York Times, and Money Magazine. She can be reached at Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.



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