What are consumer discretionary stocks and ETFs?

Consumer discretionary is not the same as consumer staples, which relates to items people need every day, such as food, beverages, household and personal products. In other words: You always need soap and a toothbrush, but a big-screen TV and a designer handbag, not so much.   

There are plenty of big-name companies in the consumer discretionary space, examples of which can include Amazon (AMZN), Tesla (TSLA), Lululemon (LULU:NASD), Alibaba (BABA) and The Walt Disney Company (DIS).  

There are also a lot of household names — selling everyday items — within the consumer staples sector. As examples, some names you might recognize include: Procter & Gamble (PG), Costco (COST) and Dollarama (DOL:TSX).   

Some companies may look like they fit into a discretionary category, but technically don’t, such as Apple (AAPL), which falls under the Information Technology sector’s consumer hardware industry. It is nonetheless closely tied to the health of the economy and consumer spending trends. You could even argue that Apple offers a consumer staple, given how much we rely on our phones these days. 

What goes up must go down (and vice versa), right? That’s how cyclical stocks work. In good economic times, consumer discretionary companies tend to do well, as people open their cash-flush wallets to spend their dollars on big-ticket entertainment, travel and consumer electronics.  

In worsening economic environments — amid a recession, periods of high inflation and rising interest rates or worsening job prospects, for example — people typically tighten their belts and spend less money on discretionary purchases.  As a result of these types of external catalysts, shares of companies that sell discretionary products and services tend to have more volatility, rising and falling based on how the economy is changing or how the market anticipates change.  

While consumer discretionary and consumer staples both cover industries that involve people buying things, they’re not the same. The latter covers all the things people need daily, such as food and hygiene products, so the sector’s fortunes are perceived to be fairly consistent. Staples stocks therefore tend to have more consistent earnings, lower volatility and growing dividends, compared with discretionary stocks.

Both consumer discretionary and consumer staples sectors have an index of their respective stocks on the S&P 500, and each has an ETF that mirrors their performance. XLY is the Consumer Discretionary Select Sector SPDR (Standard & Poor's Depository Receipt) ETF, while XLP is the Consumer Staples Select Sector SPDR ETF. These ETFs provide a way for investors to measure, track and invest directly in a representative basket of consumer discretionary or staples stocks.   

As economic conditions shift, the consumer discretionary and consumer staples indices — and by extension, their ETFs — will reflect how the market broadly expects consumer spending to change. The ETFs offer a way for investors to buy or sell based on this volatility. 

People who invest in consumer discretionary stocks may enjoy that it’s a sector full of products and services that we interact with every day. It can be easy to understand how the things companies are selling work as well as the economic shifts that impact these operations because we feel them ourselves. For novice investors, these businesses can seem more tangible and directly connected to the broader economy than other industry sectors. 

Consumer trends can be a very powerful market force, and consumer discretionary stocks do offer the potential for high returns. However, the risk is also typically larger than with staples stocks. If consumer confidence is shaken by any number of external variables, discretionary purchases often get cut from household budgets first.  

Here are the most popular ways to invest in the consumer discretionary sector:  

Investment risk is relative, and the consumer discretionary sector offers the benefit of being full of household brand names. These are not obscure, speculative stocks, and in that sense, the sector may be considered less volatile than others. However, as with any investment choice, the consumer discretionary sector does come with some risks.   

One of them is that, because these are products and services people generally interact with, they can also hold positive or negative biases that undermine their ability to objectively analyze company performance in its entirety.  

The sector is also exposed to some other risks. For instance, changes in consumer demand. Consumers can be fickle and buying patterns are driven as much by how we feel about the state of the economy as they are by the actual conditions. As such, companies in this sector may have more trouble than others sustaining sales and earnings when prevailing winds shift.  

Businesses can also struggle to accurately forecast how demand will wax and wane. For producers, meeting high demand can pose its own challenges, particularly if there are supply chain disruptions or labor shortages. Rising input costs, including higher wages, can cut into margins or force companies to raise prices, which could reduce sales. Unexpected inflation and rate increases can also send these stocks tumbling as consumer buying habits evolve.   

Volatile fiscal and economic conditions can really take a toll on a consumer’s wallet. In response, people may be less inclined or unable to spend on discretionary items, reducing company sales and earnings. For example: Throughout 2022, as the U.S. Federal Reserve raised interest rates seven times, the markets anticipated a severe impact on consumer discretionary spending, causing the MSCI World Consumer Discretionary Index, an index which tracks the performance of 160 consumer discretionary companies, to fall by 33.36%.  

On the other hand, those who invested in the consumer discretionary sector coming out of the 2008 financial crisis did well: Over the 13 years from 2009 through 2021, the Consumer Discretionary SPDR (XLY) ETF did not have a single losing year, averaging total returns of 21.24% per year.  

In times of economic uncertainty, consumer staples stocks are less impacted than discretionary stocks, making them a more conservative investment. In the tumult of 2022, for instance, the MSCI World Consumer Staples Index fell only 6.13%. As a defensive sector, consumer staples are considered a safer investment for investors seeking low volatility and steady growth.  

While these sub-sectors are all cyclical, each will face its own economic and market dynamics that may lead to an investor overweighting or underweighting them compared to the broader index.

Many investors may consider buying into the consumer discretionary sector, or its individual stocks, right after a recession ends. This can be an inflection point when consumers begin to have the confidence to spend more freely again.  

Of course, it’s impossible to time the market. However, the Consumer Confidence Index can provide a gauge based on a monthly survey of U.S. consumer attitudes and buying intentions, both of their present situation and future expectations.  

Another metric to watch is the Consumer Price Index, which measures the rate of inflation. In the near term, high inflation tends to drive discretionary stocks because it inflates asset values. Having said that, high inflation has historically triggered interest rate hikes that cool the economy and restrict consumer spending.  

The stock market can impact the way people feel about these stocks, too — bull markets can lift consumer confidence and thereby spending, while bear markets can do the opposite. 

The consumer staples sector relates to goods that people use daily, including: 

The 10-year annualized return of the MSCI World Consumer Discretionary Index was 10.25% through March 31, 2023, compared to 8.85% for the MSCI World Index. However, in the 12 months prior to that same date, the consumer discretionary index lost 13.17%, while the MSCI World Index was down 7.02%.   

Through March 31, 2023, the U.S. Consumer Discretionary Select Sector SPDR Fund (XLY) ETF had a 10-year annualized return of 12.31%, and a 20-year annualized return of 11.26%.  

It is important to remember past performance is no guarantee of future results.  That's why investors should take the time to identify their time horizon and comfort with risk.

In times of economic uncertainty or slowing growth, the consumer staples sector has experienced fewer negative impacts than others. Not only is it generally well insulated during recessions, because consumers need to purchase these items regardless of changes in the economy, but also it can sometimes be less impacted by inflation, as price increases can be passed on to consumers.

Your approach will depend on your investment goals and risk tolerance. The active management of a mutual fund may be worth the additional fees if it is successful in achieving higher returns through careful analysis and allocation. An ETF, on the other hand, can provide a relatively low-cost way to simply have some exposure to the sector in your portfolio.

When investing, there is no guarantee of future returns. Major brands may be often able to reap the benefits during economic booms and continue to attract discretionary spending even in downturns. But because of their proven track record and high profile, well recognized companies' stocks can be priced at a premium.