Chisholm: 3 key themes for investors to watch now

Key takeaways

• Although prices have been rising faster than wages for much of this year, that could be set to flip going forward, based on rates of change in the data.
• This could provide a lift to consumers' real spending power, which could boost cyclical sectors generally and consumer discretionary stocks in particular.
• Financials are another key sector to watch, where low valuations and low household debt service costs could be setting up a bullish backdrop.
• Despite the bear market and recession fears, history suggests the overall stock market could surprise investors on the upside.

As the fourth quarter gets underway with stocks still in the red for the year, investors may be feeling some nagging pessimism. But my study of history and current data suggest reasons for optimism too. In particular, I believe that real consumer spending could be poised for a faster-than-expected rebound, which could provide a boost to stocks broadly and to cyclical sectors in particular. My current top picks to watch: consumer discretionary and financial stocks.

It's true that there are real risks at hand—perhaps most pressingly, the increased risk of US recession. But at times like these, it can be important to remember that predicting the market is like trying to predict the moves of a chess master. You may think you know what's coming next, but the market is already looking many moves ahead. Often, the market prices in potential bad news well before it hits the headlines. That's why even when the news cycle is at its worst, investors can often still find bright spots.

Read on for 3 opportunistic themes I'm focused on now.

Consumer spending power may start to improve

While inflation has put a clear dent in consumers’ capacity to spend this past year, their real spending power (i.e., adjusted for inflation) could be poised to rise from here. That’s because wage gains look poised to outpace price increases going forward. Indeed, over the last 6 months, small businesses’ plans to raise wages have increased much more than their plans to raise prices, according to survey data from the National Federation of Independent Business. Given that small businesses employ almost half of US private-sector workers,* that change could have surprisingly broad implications for consumers’ spending power overall.

It makes sense intuitively that it would be good news for stocks if consumer spending power strengthens. In our consumer-driven economy, greater consumer spending power can help lift many companies’ sales, earnings, and stock prices. Historical data backs up this intuition. In the past, the more small businesses’ planned wage gains have improved relative to planned price hikes, the better the S&P 500^® has performed over the next 12 months, on average.

Historically, an improving outlook for consumer spending power has tended to boost cyclical sectors—those that are most sensitive to the strength of the economy and the phase of the business cycle. Those sectors include consumer discretionary, financials, materials, industrials, energy, information technology, and communication services.

A contrarian case for consumer discretionary stocks

Consumer discretionary companies are the poster child of cyclical sectors. These companies sell nonessential goods and services—think cars, clothing, and travel. Because what they sell is nonessential, these companies' wares are among the first things consumers cut when their spending power weakens, and some of the first they add back when it strengthens.

I reviewed historical times when real consumer spending power was showing similar trends to what we're seeing today. Historically, after similar increases in small businesses' plans to raise wages relative to price hikes, consumer discretionary stocks outperformed the market over the next 12 months some 83% of the time.

This is also a sector where it's important to remember that point about the market being several moves ahead. Earnings have slumped badly in the consumer discretionary sector this year, and that slump may not be over yet. But stock prices in the sector have historically rebounded an average of 9 months before earnings do.

To be sure, there is always a risk that the economic outlook suffers a worse deterioration than anyone expects. But based on the data and my analysis of historical periods, there's a good chance consumer discretionary stocks have already bottomed.

Attractive valuations in the financial sector

Another sector I'm bullish on is financials. Financial stocks trade at a much bigger discount to the market than they have historically. That has been a bullish signal in the past: The cheaper the sector's valuations have been compared to the rest of the market, the more likely it has been to outperform the market over the following year. Financials' valuations are in the cheapest quartile of their history compared to the broad market. When that's happened in the past, they've outperformed the market by an average of 5 percentage points over the next 12 months, based on data since 1986.

That's not the only good news for financial stocks. They also are likely to benefit from exceptionally low household debt service costs. This measure, which tracks how much of households' income goes toward monthly debt payments, is in the bottom half of its historical range. That tends to be good for financial companies, because low debt costs make borrowers less likely to default on their loans.

I looked at the connection between household debt service and financial sector performance going back to 1980. When debt service was in the bottom half of its historical range, as it is now, financial stocks outperformed the market over the next 12 months about two-thirds of the time.

Now, no discussion of debt would be complete without mentioning the Fed's current interest-rate hiking cycle. But fixed-rate mortgages make up by far the biggest slice of household debt costs. By definition, existing fixed-rate home loans don't get more expensive when interest rates rise.

For these reasons I'm especially positive on cyclical sectors, particularly financials and consumer discretionary. And despite the bear market and fears of potential recession, my research tells me the overall stock market could surprise investors on the upside.

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She uses history to share probability analysis on the US equity sectors.