How a Rising Economy Could Boost These 2 ETFs

While all companies do better when the economy turns positive, certain sectors can experience dramatic improvements in performance.

May 13, 2014 at 4:13PM

Since the Great Recession ended in June 2009, the U.S. economy has expanded for almost five years, and the job market has improved. As the economy expands, cyclical stocks stand to gain. 

Cyclicality refers to the sensitivity of a stock's price relative to the performance of the economy. Cyclicals rise sharply when the economy is doing well and fall hard when the economy is down. The following graph shows gross domestic product over the past 10 years: 


During the first quarter of this year, GDP growth slowed to an annual rate of 0.1%, according to data from the U.S. Department of Commerce. While some commentators have concluded that the economy has stopped growing, economists are blaming a particularly harsh winter for slower growth in the first quarter.  

"I'm confident the first quarter numbers shouldn't be read as a signal of sustained weakness in the economy," stated Dean Maki, chief U.S. economist at Barclays. Along with other economists, Maki is projecting that GDP growth will rise to an annual rate of 3% in the second quarter.  

The U.S. employment situation is arguably improving as well.


While some observers see the glass as half-empty, emphasizing flat wages and a low labor-participation rate, the other side of the story is a basic fact: The unemployment rate is falling (i.e., the glass is half-full, and it's getting fuller). The economy added 288,000 jobs in April, marking the biggest hiring increase in more than two years. The unemployment rate has dipped to 6.3% -- its lowest level since September 2008. 

A stronger labor market is partly responsible for a rise in leading economic indicators in March, as reported by the Conference Board. "After a winter pause, the leading indicators are gaining momentum, and economic growth is gaining traction," said Conference Board economist Ataman Ozyildirim.  

Think "want," not "need"
Cyclical stocks would benefit from a stronger economy because more consumers would have discretionary income to save, invest, or spend. In fact, personal income and spending increased more than expected in March, according to data from the Commerce Department.

Some analysts contend that it's too late to rotate into cyclicals. But Federal Reserve monetary policy remains highly accommodative, economists are forecasting improved GDP growth, and there is still time before the economy reaches full employment. In a recent speech at the Economic Club of New York, Fed Chairwoman Janet Yellen said, "A return to full employment is ... projected to be more than two years away."

Within the cyclicals category, consumer discretionary stocks are poised to rise along with the economy. Unlike consumer staples, consumer discretionary purchases can be postponed until consumers feel more confident. 

Walt Disney (NYSE:DIS)is a prime example of a consumer discretionary company. Aside from motion-picture studios and theme parks, Disney owns the ABC television network, ESPN, and the Disney Channel. Demand is cyclical because a trip to Disney World or the movies can be put off until the economy gets better. On the other hand, when the economy does improve, consumers have pent-up demand and flock to Disney for its wide array of feel-good offerings.

The Consumer Discretionary Select SPDR (NYSEMKT:XLY) ETF and the Vanguard Consumer Discretionary ETF (NYSEMKT:VCR) are two good exchange-traded fund options in the consumer-discretionary sector. For investors seeking comprehensive coverage of the consumer discretionary sector, the Vanguard Consumer Discretionary ETF is the better choice, tracking 374 companies while the SPDR ETF holds 87 companies.

The Consumer Discretionary Select SPDR ETF concentrates on larger companies. The Vanguard Consumer Discretionary ETF is more focused on companies of all sizes, including small and mid-sized companies. Both funds have low expense ratios, though: The SPDR ETF carries an expense ratio of 0.17%, while Vanguard's ETF is slightly cheaper at 0.14%. 

The economy is rising
While some analysts downplay improvements in the economy and overstate the implications of short-term, seasonal GDP numbers, longer-term trends for economic growth and the job market remain positive. As the economy expands, unemployment is likely to keep falling. Short-term interest rates remain near zero. The Fed will seek to keep rates low "for a considerable time," according to the April statement from the Federal Open Market Committee.

The business cycle is likely to start gaining momentum for the next few years due to rising GDP, falling unemployment, and low interest rates. Cyclicals frequently lead the charge when the economy gets stronger and the business cycle trends upward. Now could be a good time to act, as the economy appears to be turning the corner. 

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Michael Bodman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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