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Luxury vs. Necessity in 2014: Consumer Cyclicals or Non-Cyclicals?

If you are considering buying or holding shares of consumer cyclical companies in 2014, you'd be wise to begin the decision process by reviewing the basics of the sector, as well as those of consumer non-cyclicals. Then you can look at the key market and economic points that help shed light on recent consumer trends and behaviors and, finally, decide which type of consumer company best aligns with your investment goals.

The basics of cyclicals versus non-cyclicals
Cyclicals (or consumer discretionary companies) rely heavily on the health of the economy because they provide goods and services that are often considered luxuries -- for example, fashion and entertainment. Non-cyclicals (also called non-discretionary or consumer staples companies) provide what most consider to be necessities, such as food and personal-hygiene products.

Settling the debate of cyclicals versus non-cyclicals in 2014 is not as simple as determining whether people will spend more money on Rolex watches or food for their families next year. However, there is a point at which consumer spending habits shift from luxury to necessity.

So will consumer cyclicals win the performance race again in 2014? There are at least three points that may help in your investment decisions process.

1. Contrarian considerations
If you're a contrarian investor, you may be a little concerned that consumer cyclical stocks have outperformed consumer non-cyclical stocks for two consecutive years and for four of the past five years. This is largely a result of the economic recovery and bull market that began five years ago. But how much longer can the recovery and bull market keep forging ahead?

2. The wealth effect
If you want to gauge an expectation of how consumers will spend their money, you need to consider how they feel about their money. One such gauge is the the U.S. misery index, which factors unemployment and inflation. The misery index is at a four-year low, indicating that consumers feel better about their respective personal economies than they did at the beginning of the current economic recovery. Also, stock prices are on pace for their best gains in 15 years, and home prices are now at levels not seen since 2006.

This all adds up to a "wealth effect" that can put consumers in a positive spending mood. This makes the argument for more consumer spending in the near term on discretionary goods in the non-cyclicals sector. But how much do you want to rely on feelings? Is consumers' buoyancy justified, and will it last?

3. Unemployment and wage growth
Consumer-dependent sectors rely not only on consumers' outlook, but also on their actual wealth. The unemployment rate is hovering around 7%, which is not a level that strongly supports consumer spending capacity, nor is it likely to support positive consumer sentiment for long. In addition, wage growth remains stagnant. Consider these key findings from a recent EPI report:

According to every major data source, the vast majority of U.S. workers -- including white-collar and blue-collar workers and those with and without a college degree -- have endured more than a decade of wage stagnation. Wage growth has significantly underperformed productivity growth regardless of occupation, gender, race/ethnicity, or education level.

The weak wage growth over 2000-2007, combined with the wage losses for most workers from 2007 to 2012, mean that between 2000 and 2012, wages were flat or declined for the entire bottom 60 percent of the wage distribution (despite productivity growing by nearly 25 percent over this period).

In summary, for the coming year, your decision to buy a consumer cyclicals sector fund, such as Vanguard Consumer Discretionary ETF (NYSEMKT: VCR  ) , is essentially a bet that the economy will remain healthy in 2014 and that consumers will stay in a spending mood. For the sake of comparison, buying shares of a consumer non-cyclicals sector fund, such as Vanguard Consumer Staples ETF (NYSEMKT: VDC  ) , is a bet that the economic recovery and bull market are late in their respective cycles and that consumers will be less willing to spend their hard-earned money on things that they do not need.

Buying lower and selling higher
But what is the Foolish decision? Above and beyond what you believe the economy or market may do in 2014, it is wise to frame your trading decisions around a sound investment philosophy. You shouldn't attempt to pick precise tops or bottoms for a particular stock, sector, or even broad market index. This can be a portfolio disaster waiting to happen. Rather than attempting an absolute "buy low, sell high" timing strategy, you can aim to buy lower and selling higher.

Considering that, in the humble opinion of this Fool contributor, now is a good time for a long-term investor to lock in gains -- or at least avoid buying shares -- of consumer discretionary stocks, because the sector has outperformed non-cyclicals for two years, and signs indicate that consumers -- and thus the market -- may be overly confident. This decision would be an attempt to sell higher without risking the attempt of selling highest.

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Disclaimer: The information here is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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