It's been an incredible year for the U.S. stock market, and we still have another five-plus months to go before we reach the finish line for 2016.
We began with the worst two-week start to a year in recorded history. All three of the major U.S. indexes plunged between 8% and 10%, and they would wind up moving even lower by mid-February. However, we also witnessed the biggest intra-quarter turnaround since 1933, with the broad-based S&P 500 (SNPINDEX:^GSPC) finishing the Q1 slightly positive.
More recently, we've dealt with the fallout from Brexit -- Britain's surprising exit from the European Union. The uncertainty created by Britain's sudden departure from the EU and what that might do to its economy, the EU economy, and Britain's future trade deals caused markets around the globe to dive. In the more than two weeks that have since passed, some markets have rebounded, and the S&P 500 has hit an all-time closing high.
But there are clear reasons to believe that the stock market and U.S. economy could be primed for some downside. Why would I make such a suggestion? Look no further than the group of stocks leading the stock market higher this year: consumer staples.
Consumer staples are leading the charge
Consumer staples, just as the name implies, are typically household goods that consumers will keep in their budgets regardless of how well or how poorly the U.S. economy is performing. Consumer staples would include products such as food, beverages, cleaning supplies like detergent, toothpaste, tobacco, and other items that tend to be able to transcend a dip in the economy. On Friday, the Consumer Staples Select Sector SPDR ETF (NYSEMKT:XLP) notched a new all-time high.
It's not hard to see why investors would want to invest in consumer staple stocks. Consumer staple companies tend to have reliable and predictable cash flow in any economic environment, and because of that they often pay a dividend.
Examples would include household brands giant Procter & Gamble (NYSE:PG), which sells Tide, Crest, and dozens of other products that consumers buy, and Coca-Cola (NYSE:KO), which is a diversified beverage powerhouse. Procter & Gamble is currently paying out a 3.2% yield and has raised its payout in 60 consecutive years, while Coca-Cola is yielding 3.1% and has increased its dividend for 54 straight years. Both yields are substantially higher than the S&P 500 average and far more than you'd get with essentially any bond or CD at the moment. Plus, these are well-recognized brand-name companies that'll be there when you wake up in the morning.
Why this is a concern
But ask yourself this question: Why would investors be buying consumer staples now? We have historically low lending rates that have given businesses access to cheap and plentiful capital with which to expand, hire, or acquire other companies. A low-yield environment is conducive to growth and not necessarily to consumer staples, which tend to plod along with revenue gains in the low-to-mid single-digits each year.
Yet that's not what we're seeing. Instead of investors flocking to riskier growth stories, such as biotech, and sectors that tend to benefit from a growing economy, such as financials, investors have been bidding up the valuation of consumer staples stocks, which are viewed as a more defensive investment. In contrast, the biotech industry and financial sector are among the worst performers in 2016.
Furthermore, history has shown us more often than not that when the stock market is struggling to motor higher but consumer staples are strong, a recession could be around the corner.
You'll note that in 2007 and 2008, consumer staples held up well, hitting new all-time highs, all while the SPDR S&P 500 ETF (NYSEMKT:SPY) that tracks the S&P 500 was in retreat mode. We can see that divergence to a lesser degree beginning in January of this year and continuing through today.
If we pull our chart out a bit further, we can see the exact same occurrence in 2000 as consumer staples stocks rallied and the S&P 500 fell. What this is telling us is that when consumer staples rally without a commensurate move in the underlying indexes, investors are highly skeptical -- and when investors are skeptical, a recession could be in the offing.
Stay the course
Of course, with the long-term mindset we like to ingrain in our readers here at The Motley Fool, a recession isn't anything to get into a big fuss over.
As we all know, peaks and troughs are a natural part of the economic cycle, no matter how much the Federal Reserve tries to intervene to smooth out the rough edges. But more importantly, the U.S. stock market as a whole has a tendency to head higher over the long term. This would suggest that staying invested and sticking to your investment thesis in high-quality companies is going to be your best recourse if the U.S. economy and stock market are indeed headed for a rough patch.
If anything, a dip in stock prices should be welcome for investors. Based on data from Yardeni Research, we've had 35 stock market corrections in the S&P 500 of at least 10% (rounding to the nearest integer) since 1950, and in every single instance, those declines have been safely put in the rearview mirror. Sometimes it took weeks, months, or in rarer cases, years to erase the declines of a stock market correction or recession, but high-quality company valuations do have a tendency to move higher over time.
At this point, long-term investors should be hoping for some downside so you can pick up high-quality stocks on the cheap.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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