Consumer Stock Rally Doesn't Signal Economic Recovery

By Fabio Alves and Michael Tsang

Aug. 25 (Bloomberg) -- Just because consumer stocks are staging the biggest rally in five years doesn't mean the economy is about to recover.

As Lowe's Cos., Wendy's International Inc. and Starwood Hotels & Resorts Worldwide Inc. led a 7.6 percent advance in consumer stocks this month, the extra yield bond investors demanded to own the industry's debt rose to 2.5 percentage points over U.S. Treasuries. Every time bondholders sought that much compensation to guard against default, shares of retailers, restaurants, and hotels slumped an average 16 percent, according to data compiled by Bloomberg.

Standard Life Investments, Harvard University's endowment and hedge fund Appaloosa Management LP, which manage almost $300 billion, are avoiding the shares as Americans rein in spending to cope with the highest unemployment rate in four years and faster inflation. Profits at consumer discretionary companies are forecast to be the worst since 2001, Bloomberg data show.

``It's a rally that we think will inevitably roll over,'' said Andrew Milligan, the Edinburgh-based head of global strategy at Standard Life Investments, which oversees about $242 billion. ``Investor confidence has started to ease back and earnings numbers have generally been negative. The credit side just reinforces our downbeat views.''

Stocks Versus Bonds

Consumer shares have risen almost four times as fast as the Standard & Poor's 500 Index in August, sending the S&P 500 Consumer Discretionary Index toward its biggest monthly advance since an 8.9 percent increase in October 2003. A 22 percent drop in oil since its July peak and speculation the Federal Reserve will hold off raising interest rates after seven cuts in the past year improved prospects Americans will spend more. Consumer stocks in the MSCI World Index are up 1.8 percent this month.

Futures on the S&P 500 lost 0.4 percent at 11:14 a.m. in London as oil's climb above $115 a barrel sent retailers lower.

This month's gains in consumer stocks coincided with an increase in the difference between yields of U.S. retailers' bonds and those of government debt to 2.47 percentage points as investors demanded more protection against the likelihood of default, according to data from New York-based Merrill Lynch & Co.

When the gap exceeded 245 basis points in 2000, 2002, 2005 and March of this year, the consumer discretionary gauge lost an average of 16 percent over the same span, the data show. A basis point is equal to 0.01 percentage point.

Shares of Mooresville, North Carolina-based Lowe's, the world's second-largest home-improvement retailer, surged 22 percent this month as the extra yield investors demanded to own the company's 5.6 percent bond due in 2012 widened 23 basis points over U.S. Treasuries.

`Voting With Bondholders'

That's more than three times the average increase of A- rated corporate bonds over the same period, Merrill's data show.

The premium on Wendy's 7 percent bond due in 2025 climbed as much as 33 basis points above U.S. government debt this month, almost triple the gain in spreads of similar BB-rated debt. The Dublin, Ohio-based hamburger chain's stock added 16 percent.

The disparity between the stock and bond markets comes as analysts are forecasting the industry's biggest full-year profit decline since the last recession in 2001. Earnings at S&P 500 consumer-discretionary companies will drop 22.9 percent this year, data compiled by Bloomberg show.

``I would be inclined to vote with the bondholders,'' said Jack Ablin, who oversees $65 billion as chief investment officer at Harris Private Bank in Chicago. ``They're sensing there's still credit deterioration going on in the group.''

Earnings Plummet

Lowe's, Wendy's and Starwood, the White Plains, New York- based company that runs the Westin, St. Regis and W hotels, all reported lower earnings for the second quarter. Industry profits have dropped 54 percent on average, the highest on record for Bloomberg data that started in 2001.

LPL Financial's Jeffrey Kleintop expects consumer stocks will continue to do well as profits decline less than analysts estimate. More than 91 percent of the S&P 500 retailers that have reported second-quarter results so far topped Wall Street's consensus forecast, data compiled by Bloomberg show.

``The outlook isn't rosy, but certainly better than what had been priced into those stocks,'' Kleintop, the Boston-based chief market strategist at LPL, which oversees $273 billion, said in a Bloomberg Television interview.

Fed Rate Cuts

Consumer stocks in the U.S., where the Federal Reserve cut its benchmark interest rate to 2 percent from 5.25 percent in the past year, are outperforming the rest of the world. The MSCI Brazil Consumer Discretionary Index lost 9.8 percent in August, while retailers, automakers and electronics makers in the MSCI Asia Pacific Index fell 2.3 percent.

To maintain the advantage, U.S. retailers will have to defy an unemployment rate that rose to 5.7 percent last month and the fastest inflation in 17 years. The economy, buffeted by the biggest U.S. housing slump since the Great Depression and more than $500 billion in bank losses, may grow 0.45 percent next quarter, or about a third the annual rate of 1.2 percent forecast this quarter, according to data compiled by Bloomberg.

``You only have so many dollars or francs or euros in your pocket,'' said Robert Weissenstein, who helps oversee $1.3 trillion as chief investment officer at Credit Suisse Private Bank. It's difficult to turn bullish ``as long as you get mixed to negatively biased jobs data,'' he said from Tucson, Arizona.

Harvard Endowment

Harvard's $34.9 billion endowment, the biggest of any university, sold its holdings in 79 of 92 consumer companies including Lowe's, Wendy's and Starwood, during the second quarter, the Boston-based college fund's filing with the U.S. Securities and Exchange Commission compiled by Bloomberg show.

Appaloosa, the Chatham, New Jersey-based hedge-fund firm run by former Goldman Sachs Group Inc. bond trader David Tepper, held 10.4 percent less in consumer stocks at the end of the second quarter, partly after selling its 175,000 share stake in Starwood, filings compiled by Bloomberg show. Appaloosa, which owned equities valued at $3.1 billion as of June 30 and also invests in bonds, has posted average annual returns of about 25 percent in its Palomino Fund since the beginning of 1995.

``The corporate bond market has sold off first, fastest, and then equities follow after,'' said Standard Life's Milligan. ``What the credit markets are telling us is that we need to still be cautious.''

To contact the reporters on this story: Fabio Alves in New York at falves3@bloomberg.net; Michael Tsang in New York at mtsang1@bloomberg.net.