Consumer Cyclicals Suggest a Slowdown Is at Hand

Economic data such as retail sales say otherwise, but these stocks have been sliding -- and they're often a leading indicator.
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The stock market is a giant predicting engine, a million minds gathering data, filtering through a mass of ideas, reacting -- sometimes violently -- when new information comes to bear.

This machine is often better at foretelling the U.S.'s economic future than any roomful of economists. Take March 1991, for instance, when the down-on-its-luck economy finally started to claw its way back. Old news for a stock market that had hit a trough half a year earlier. Or 1994, when the

Federal Reserve

was working to cool the economy. Even though the Fed didn't put through its last hike until February 1995, the market pulled out of its doldrums that December. In effect, it forecast the central bank's success in bringing the economy in for a soft landing.

And now again the Fed is trying to cool the economy, hoping to rein in domestic demand before it brings on a higher rate of inflation. Here, too, stocks have told the tale. Consumer cyclicals -- a broad group of stocks that includes retailers, carmakers, homebuilders and other companies dependent on the U.S. consumer -- topped out in early April. Since then the

S&P Consumer Cyclical Index

has fallen more than 10% in a mostly flat, broader market, despite a string of stellar quarters. Experience has shown that when these stocks fall off, consumption will come down. It does not matter that sales, as shown by the August

retail sales report

Tuesday, remain robust, or that third-quarter earnings look strong.

"It's not so much that things are bad. It's that they have to get worse," John Manley, portfolio strategist at

Salomon Smith Barney

, says of the consumer cyclicals. "If someone says, 'They've got good earnings,' it's like saying, 'He's the healthiest guy on death row.'" Manley went underweight the stocks in June, as it became clear that the Fed was on a tightening course: "I just couldn't see any way these guys were not going to get themselves in trouble."

It is easy to think, Manley cautions, that the bounce the consumer cyclicals have seen since August represents a turn. Peak-to-trough, the stocks have fallen about as much as they did in 1994. It's been about a year since homebuilders peaked -- about as long as it took before the turn in 1994. But with industry analysts (somewhat ridiculously) forecasting a 21% gain in the group's earnings next year, according to

First Call/Thomson Financial

, signs of the expected slowdown in consumption are at best nascent.

Consumer Cyclicals -- Heading Lower
The S&P Consumer Cyclicals Index

Source: Baseline, Standard & Poor's

"The timing is always a little uncertain where consumption is concerned," notes Mickey Levy, chief economist at

Banc of America Securities

. "Based on the Fed tightening, the slowdown in money growth, the flattening of the yield curve and higher oil prices, one would expect a moderation in the rate of consumption. But the rate of growth has just been extraordinarily strong -- this quarter it looks like there's going to be 4% consumption growth."

That high rate of growth has been one reason

J.P. Morgan

strategist Doug Cliggott has been down on consumer cyclicals for much of the year. "The reason we've been underweight hasn't been that we've seen retail spending slowing down, but that we see retail spending at a 10-year high," he says.

When it becomes apparent that spending is going to slow down, the "all clear" will be sounded, says Manley -- and not just for the consumer cyclicals. "The prices go down because it becomes apparent that the consumer has to stop," he says. "When earnings come down, it's the confirmation that the Fed's done it. I'm still looking for signs of that earnings slowdown. We're going to be off to the races when we see it."