It is commonly proffered that reduced energy prices ultimately fuel the economy, as households redirect energy-related savings to other facets of consumption. Retail sales data for recent months are inconsistent with this assertion though, and the April sales figures (released May 13, 2015) exemplify this point. Growth in retail sales was flat last month, versus expectations for an increase of 0.2%. The following headlines illustrate pundits’ dismay at the breakdown in the purported linkage.
In contrast to conventional thinking, we submit that some level of consumer retrenchment as energy quotes soften is the norm rather than the exception, and should be expected. Our outlook is supported by an examination of the performance of the S&P 500 Consumer Discretionary Index (a rough proxy for consumption) relative to Sweet Crude Futures (a surrogate for energy prices). Comparing 3-month changes in these two series since 2002 (as far back as we can access data for both indices) reveals a positive, rather than negative long-term correlation of 0.25. While this indication of coincident movement is not eye-poppingly high, it is statistically significant, and thus poses a valid challenge to oft-circulated explanation of the relationship between energy prices and consumption.
The chart above highlights the instability of the relationship over time. Notice, for instance, that when oil prices have risen by about 15%, discretionary stocks have been roughly as likely to rally as to correct.
We also examined rolling 24-month correlations between the series, in an effort to gain insight into the extent to which the association has changed over time, and perhaps how strong the connection might be going forward. The following chart illustrates the output of this review.
24-month correlations have varied wildly over time, from stopping briefly in the realm of highly negatively correlated at the end of 2007, to hanging out in the backyard of highly positively correlated for much of the period between 2009 and 2013. Currently, the linkage is quite weak and modestly negative, however, our momentum model anticipates an imminent upturn. As such, we think it reasonable to expect that the prospects for Consumer Discretionary stocks will be directionally tethered to the path of energy prices in months to come.
As our medium-term momentum model suggests the rally in Energy will endure into summer, and our long-term oscillator is expected to bottom for Energy later this year, we see upside to current energy quotes. The bright prospects for the sector should, in turn, translate to price gains for discretionary stocks. This message is consistent with signals from our direct, sector level momentum work, which identified the Consumer Discretionary sector as a compelling overweight coming into this year. Our interpretation of fundamental trends likewise supports the prospects of leadership from the discretionary sector (in short, we anticipate mounting upward wage pressure as a key driver of consumer confidence and ultimately spending).
Bottom line: Our long-term momentum work continues to favor Consumer Discretionary stocks (though the sector might be stretched over the medium-term). However, our bullish bias is not at all predicated on the popular thinking that individuals feel emboldened to spend elsewhere as a result of reduced Energy prices. Quite contrarily, we favor Discretionary stocks because we expect Energy prices to continue to rally. In aggregate, history has demonstrated a direct rather than inverse relationship between changes in Energy prices and the performance of domestic Consumer Discretionary stocks. Further, the current backdrop for correlations point to a strengthening of the historical bond in months just ahead.
While the conventional explanation that energy savings fuel potential consumption in other areas might, at first blush, seem to make intuitive sense, an objective review of the data suggests instead that big energy price declines tend to stoke fears of deflation and a worsening environment to come; it appears as though significant price rallies in the energy complex are perceived to signal good times to come and prompt increased confidence. This hypothesis fits with other empirically demonstrated behavioral biases, such as the tendency of small investors to sell equities closer to bottoms and buy at around tops (thus ensuring a lower return than a buy-and-hold strategy), and suggests that sentiment is quite influential in motivating individuals’ conduct.