Summary
- U.S. Employee Earnings are a strong leading indicator of Consumer Discretionary Stocks.
- Based on the relationship, Consumer Discretionary Stocks are below their long-term value.
- It is expected that Consumer Discretionary Stocks will increase by roughly 2.76% in the next month.
- This idea was discussed in more depth with members of my private investing community, The Lead-Lag Report. Get started today »](https://seekingalpha.com/checkout?service_id=mp_1302)
The consumer is one of the primary drivers of the U.S. economy, with consumers spending $14.5 trillion in the 2nd quarter of 2019. Consumer spending can be roughly split into two sectors: consumer staples and consumer discretionary. Consumer staples cover goods that are considered to be essential requirements for a household, while consumer discretionary are goods that, while wanted, are not necessary for the normal functioning of a household. One can hypothesize that consumer staples are inelastic goods in terms of household income, whereas consumer discretionaries are elastic to household income. One can then extend that hypothesis that the value of consumer discretionary stocks is driven by U.S. household income.
This hypothesis is tested by using U.S. employee earnings as a proxy for household income. The S&P 500 Consumer Discretionary Index was used as a proxy for U.S. consumer discretionary stocks, which can be directly invested in through the iShares S&P 500 Consumer Discretionary Sector (UCITS) ETF. The two data series were tested for stationarity using the Augmented Dickey-Fuller test and were found to be non-stationary, integrated to order 1. To test if there is a long-run, cointegrating relationship between the two, an ordinary least squares regression was estimated between the S&P 500 index (dependent variable) and lagged U.S. Employee Earnings (independent variables), with the natural logarithm of both used to transform the data such that it follows a normal distribution more closely. The regression results are displayed below:
As such, a 1% increase in U.S. employee earnings leads to an expected 5% increase in the expected fair value of the S&P 500 Consumer Discretionary Index. The relationship is tested to determine whether it is non-spurious by testing the residuals for stationarity using the augmented Dickey-Fuller test and found to be stationary, indicating that a cointegrating relationship exists and the relationship between the two variables is super-consistent. The long-run fair value of the S&P 500 Consumer Discretionary Index, as estimated from U.S. employee earnings, using a log-axis, is displayed below.
One can see from this graph that the consumer discretionary index has hovered below its long-run fair value since the end of August 2018.
While it is useful to determine the long-run fair value, the old expression that “the market can be wrong longer than you can be right” holds. Therefore, it would be useful to be able to predict future values of the index. Fortunately, if a cointegrating relationship, one can estimate an error-correction model. Simplistically, it estimates what percentage of the residual in the cointegrating relationship reverts to zero in time. The ECM regression was estimated, and the results are shown below.
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This article was written by Michael A. Gayed. An author on Seeking Alpha and founder of the Lead Lag Report.
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