The Services Sector Mean Reversion Continues

Key Points

• The ISM Services report¹ for March highlights the surge we have been expecting.
• Job growth, particularly across services sectors, continues to recover strongly.
• Consumption of services should continue through summer until it levels off.

I have written about the mean reversion opportunities across many important spending categories for six months. Monday’s ISM Services report highlights the robust recovery we are seeing across many of 2020’s laggard industries like travel, restaurants, and leisure services. As consumers were stuck in their homes and not able to gather as they love to do, the durables side of the economy experienced a historic renaissance. The global pandemic disrupted supply chains across the world while the stay-at-home mandate created wicked demand for all kinds of consumer durables. If you have tried to buy a refrigerator or washer/dryer lately you know what I mean. The shipping delays have been unprecedented leading to strong pricing power for the leading brands serving important consumption categories. While many of the supply chain issues are in the process of being solved, a new pick-up in demand is happening across the services sector. Many of the leading brands serving this sector had very difficult years last year but the tide is turning, and consumer demand is snapping back aggressively. As investors across important consumer trends, we are very excited about the services sector exposure we currently have. For perspective, I have inserted a chart of the ISM Services report that goes back to 1997. As you can see, the services sector and readings from ISM have never been higher. When the rubber band stretches one way too far, the snap-back is often just as fierce in the opposite direction. That’s what we are seeing now and why many of the top services stocks are sitting at all-time highs even as their businesses are just now starting to recover. Reminder: a reading over 50 indicates growth in the services sector so a 63.7 reading says there’s epic demand as the economy opens more broadly and vaccination rollouts continue. March is the first month the Services report has reached the recent 64.7 level seen in ISM Manufacturing.

Source: Bloomberg

The recovery appears to have multi-month legs before it should be expected to revert back to a more normal range. Supply chain issues and a lack of sufficient labor (why work if you’re receiving unemployment benefits) are two key reasons the most in-demand brands will have strong pricing power which we will start seeing in quarterly earnings reports. In my opinion, analyst estimates are too low for many of the services stocks and revisions will begin once we start reporting earnings later this month. Everyone expects a return to travel and eating out etc., but I see no real evidence of this knowledge when I look at the revision trajectory from sell-side analysts. There’s a big ah-ha moment coming for many of these services-related stocks.

Think about the services that are just beginning to open across the country. The pent-up demand for many of these services will be historic for the bulk of this year. Things like: movie theatres, theme parks, air travel, restaurants, hotels, Airbnb’s, sporting events (this week’s Texas Rangers game was at full capacity), and casinos are seeing strong interest. Last week I took the family for a 2-day quick vacation for our daughter’s spring break and the hotel was packed and prices were high. Hotels and airlines in particular should experience historic pricing power until we get back to normal.

Then there’s the not so obvious potential recovery industries like the pent-up demand for elective surgeries, long overdue doctor visits and the prescriptions being written post-visit. Additionally, the apparel industry should see a strong snap-back as people purchase “going-out” clothes, cosmetics, shoes and accessories. Here’s the rub, very few portfolios have sufficient exposure to the services and companies that should experience strong rebounds.  Sometimes the most obvious opportunities get overlooked.  We are very excited about the exposure we have to this important sector.

The Employment Report, March 2021

There’s no doubt, hiring has picked up. I suspect hiring across the services sector would have been even more robust were it not for the extension of unemployment benefits. Total nonfarm payroll rose by 916,000 in March as the unemployment rate fell to 6%. Real unemployment is likely a bit higher, but the trends continue to move in the right direction. Within the report, gains across leisure & hospitality, public and private education, and construction were the most favorable. Furloughed employee hiring was strong as many laid off workers returned to their positions. With more people having jobs, more consumption will occur and the brands that we favor most in consumption categories should see strong revenue and earnings trends. Here’s the inputs that drive consumption:

Consumption capacity = the sum of wages and all income + unemployment benefits + savings rates + household net worth gains + the amount of revolving credit card availability + consumer sentiment.

For now, wages are strong, many are rising, unemployment benefits are still coming, savings rates are historically high at over $1.5 trillion, and debt to total household net worth are at a 40-year low. All that spells positive trends for continued and accelerated consumption. I call that goldilocks for the consumer and consumer stocks.

Consumer Services Stocks Appear Very Attractive

The market is a discounting mechanism and stocks tend to see the future before the actual data proves the thesis. Nowhere is that more evident than in the stock charts of many of the top services brands. Great businesses on sale will always attract buyers and the recovery trajectory in stocks across services is clearly in place as many names hit 52-week highs. We still need the confirming evidence of the recovery which should begin to arrive this earnings season and with further confirmation in the July reports. This should lead to further positive revisions and attractive stock price gains. Again, everyone is talking about this obvious leisure recovery but very few investors have sufficient exposure to benefit from it.

Investing in the most relevant, admired brands serving the services sector has never been easier.

¹The ISM Report On Business (ROB), also known as the ISM Report, is the collective name for two monthly reports, the Manufacturing ISM Report On Business and the Non-Manufacturing ISM Report On Business, published by Institute for Supply Management.

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This information was produced by and the opinions expressed are those of the author as of the date of writing and are subject to change. Any research is based on the author’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however the author does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios managed by the author, and do not represent all of the securities purchased, sold or recommended for client accounts.  The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results.