Get Ready to Profit from the "Return of the Consumer"

After a stunning 15% surge since mid-November, the market has struggled in the past month, trading up and down in a tight 1% band. Problems in Europe have reignited and many on Wall Street are expecting consumer spending to weaken during the rest of the year. It is all making the case for a bull market very difficult, except for a key report the U.S. Federal Reserve recently released.

I am not talking about the Fed's stance on interest rates, or whether it will maintain record bond purchases. This report is even more important because it concerns the driver to 70% of the nation's economy and, despite current bad news, it's pointing straight up.

But first, a bit of background...

Can Mr. Market climb this wall of worry?
They say stock prices increase in the face of overwhelming risk, that the "wall of worry" is just the daily protest of market makers. In the past few weeks though, it seems some walls may be insurmountable.

Bonds of European peripheral countries and stock markets around the world slid in the week of March 18, when it looked like Cyprus would not be able to negotiate a bailout for its relatively small economy. The fact that the world markets shook from the stumble of a $22.4 billion economy reminded many investors that the European debacle is far from over.

Of bigger concern is the fact that many analysts forecast consumer spending will slow this quarter and possibly for the rest of the year. Consumers have been struggling with the 2% hit to paychecks from the expiration of the payroll tax cut in January and rising gas prices in the first two months of the year. As a result, monthly consumer spending was basically flat in February, and JP Morgan expects it to grow by just 1% in the first quarter, well off the 3.6% pace in the same period of 2012.

The job market certainly hasn't helped consumers. An unemployment rate still well above 7% means that employers see no need to raise workers' wages, which increased just 0.1% in February from the same time last year and actually fell 0.6% from January.

Considering the fact that consumer spending counts for 70% of the nation's economy, this all paints a pretty bleak picture.

That is, except for one key report.

Seeing the green shoots when they're just seedlings
The Fed issued an update to its Household Debt Service and Financial Obligations Ratios on March 13 and the data could hold the key to some surprisingly strong consumer numbers in the quarters to come.

The household debt-service ratio, a measure of debt payments as a percentage of disposable income shown in the graph below, fell to 10.4% in the fourth quarter of 2012 and was the lowest on record. The financial obligations ratio (FOR) adds in automobile lease payments, rents and insurance. The fact that renters' debt obligations, shown on the right axis below, have also fallen to near record lows means that stronger personal balance sheets are not just a byproduct of higher home prices.

Americans have genuinely cut back on their spending in the past four years, to the point that the debt they owe is well under the historical average. With debt obligations this low, it isn't hard to see how retail sales could get a boost from a consumer wary of cutting back and anxious to splurge.

Beyond the responsible deleveraging, the market may still be underestimating the rebound in the housing market. That's the view of Mark Zandi, leading economist at Moody's Analytics, who recently told Bloomberg that he thinks the market is, "underestimating the juice [the housing market] is going to provide to the economy," and could see gross domestic product growth around 4% in the near future.

The market for housing has entered a virtuous cycle where surging prices (up 9.7% in the year to January) lead to higher optimism, pushing prices higher still. With home prices and the stock market posting double-digit returns in the past year, consumers are feeling more confident.

Simply put, they are going to start spending again.

Not all consumers are created equal
Before you rush into retailers and other cyclical stocks, know that the coming consumer boom might be lop-sided. Higher payroll taxes and prices at the pump have hit lower- and middle-income consumers disproportionately. This may be evident in the decline in year-over-year restaurant dining, down 0.7% in February and 0.6% in January, against gains across other sectors of consumer spending. In addition, those renting a house have not benefited from the increase in home prices and so may not feel as rich as property owners.

Given this, retailers with upscale brand names could outperform their discount-retailer peers. These include luxury stocks such as Coach (NYSE: COH) and Tiffany Co. (NYSE: TIF), which have some of the strongest brands in fashion. Both stocks have underperformed the general market during the past year, with Coach seeing significant weakness after a disappointing 2012 fourth-quarter report.

Conversely, discount retailers such as Shoe Carnival (Nasdaq: SCVL) may feel the pinch as the scenario drives higher income consumers to spend at the brand stores, while lower income shoppers continue to deleverage.

Credit card companies may be the safest play, as they collect transaction fees no matter where consumers go. While the lower interest payments on debt may hit credit card issuers, largely banks and credit unions, payment processors like Mastercard (NYSE: MA) and Visa (NYSE: V) make money despite your card balance.

Risks to Consider: The larger global headline risks could pull retailers down in the short-term or cause sporadic sell-offs in any particular day. These shouldn't be enough to derail a cyclical rebound in consumer spending, but investors should be ready for increased volatility until earnings are released and data affirm higher prices.

Action to Take -- The great deleveraging brought on by the housing crash may be over and a rising market is making consumers feel wealthier and more confident. Investors may want to increase their allocation to strong brands and high-end retailers before earnings surprise to the upside.

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Joseph Hogue