Consumer Staples & Health Care Set to Have Their Day in the Sun Once Again

Period of Out-performance Dead Ahead

By Chris Puplava, March 21, 2007

Previous commentaries on the state of the consumer, housing, and the general economy have made clear that the economy is slowing as the consumer retrenches amidst a housing recession. As consumers reign in spending on discretionary items, the percentage of non-cyclical items such as food, health care, cosmetics and toiletries, total retail sales rises. This results as these items are inelastic goods making them non-cyclical as compared to plasma televisions, computers, jewelry and so forth, that are not as dependent on economic growth.

When non-cyclical relative retail sales rise during periods of economic slowing, the stocks of companies which produce these goods rise relative to the overall market (S&P 500), benefiting from sector rotation as money flows out of cyclical sectors and into non-cyclical sectors.

The converse occurs when the economy reaccelerates and money rotates out of the defensive non-cyclical sectors and into early cyclicals. Non-cyclical sector sales continue to rise with the expanding economy, just at a slower pace than cyclical sectors. With money flowing out of defensive sectors at the same time non-cyclical sales continue to rise leads to a compression in valuations. This continues until the point at which the economy slows and money flows back into defensive sectors and bids up prices at a faster pace than sales growth, leading to valuation expansion.

After more than four years of economic expansion, the valuation levels for the S&P 500 Consumer Staples Index and the S&P 500 Health Care Index have been compressed to attractive levels. The consumer staples sector's price-to-earnings ratio (P/E) has been compressed to decade lows (Figures 1 & 2), as has the price-to-sales (P/S), price-to-cash flow (P/CF), and price-to-book value (P/BV) ratios. Moreover, the group has been steadily increasing its annual dividends per share leading to a ten-year dividend yield high (Figure 3).

Figure 1: P/E Bands, P/S

Figure 2: P/E, P/CF, P/BV, PEG

Figure 3: P/E, Dividend Yield, Annual Dividends/Share

Source: Ford Equity Research

The same picture is true for the health care sector, where years of economic expansion and underperformance of the S&P 500 with consistently rising sales have led to a compression in valuations when looking at any valuation multiple (Figures 4 & 5). And like the consumer staples sector, the dividend yield has reached a ten-year high that was last seen in 2002 and 1997 (Figure 6).

Figure 4: P/E Bands, P/S

Figure 5: P/E, P/CF, P/BV, PEG

Figure 6: P/E, Dividend Yield, Annual Dividends/Share

Source: Ford Equity Research

The fundamental picture arguing for health care relative out-performance was given previously (Observation: 01/17/2007) and will not be presented in this article. Instead, the developments arguing for the outperformance for various industries within the consumer staples sector are the focus of the commentary provided below.

The following charts present the linkage between a slowing economy and the relative performance for the non-cyclical sales of consumer staples. One measure of economic activity, the ISM Purchasing Managers Index (PMI), is a leading indicator of consumer staples relative sales. Figure 7 below shows the ISM PMI inverted for directional similarity to the relative shipments of food and beverage shipments. When the ISM PMI decelerates (rises in graph), relative food and beverage shipments rise as the economy slows. The ISM PMI has been decelerating since 2003 as the index has fallen from 63 to roughly 52 currently, with relative food and beverage shipments rising in 2006, rebounding once again after a prolonged period of deceleration since early 2003 as the economy expanded.

Figure 7

Source: Moody's Economy.com/BOC, ISM

The next chart shows how the stock market fared when relative non-cyclical sales accelerate (falls in Figure 8). As the economy slowed and discretionary incomes fell, spending on luxury items and non-essential goods fell while non-cyclical sales remained steady leading to a sharp spike in non-cyclical relative sales going into the 2001 recession. The acceleration in non-cyclical relative sales preceded the bear market and plunge in the S&P 500, and the deceleration of non-cyclical relative sales (rise in Figure 8) in early 2003 marked the bottom of the bear market.

Figure 8

Source: Moody's Economy.com/BOC

At the same time that the S&P 500 was peaking in 2000, the relative strength of the consumer staples sector was bottoming. A three year period of relative out-performance began until the relative strength of the consumer staples sector peaked in late 2002, the same time the S&P 500 bottomed.

Figure 9