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Michael Fowlkes' Analyst Insights

Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

May 6, 2013 - Profit from improved consumer confidence

The recent economic crisis took its toll on consumer confidence, but over the last two years we have seen a slow but steady rise in overall confidence. When consumer confidence is weak, we tend to see weakness in consumer discretionary stocks, and the opposite is true when consumer confidence starts to improve.

There were a few reasons why consumer confidence and discretionary spending fell so far during the recession, including high unemployment, the collapse of the real estate market and a weak stock market.

Seeing so much equity come out of their homes and investing accounts, coupled with anxiety over the possibility of losing their jobs, led consumers to cut back on spending wherever possible and to focus more on their savings.

Companies as well as individuals trimmed expenses, such as travel, wherever possible to make up for lower revenues during the recession.

The good news is that the economy is improving. Unemployment in March fell to 7.5%, which is the lowest we have seen in four years. The housing market is also rebounding, and the S&P/Case Shiller index, which tracks home prices in 20 cities, rose 9.3% in February versus the same period last year? the biggest year over year jump we have seen since 2006. Additionally, the stock market has also been strong, with the DOW and S&P 500 both setting new all-time highs.

With unemployment falling, home prices and the stock markets on the rise, it should come as no surprise that consumer confidence has also continued to improve. In April, the Conference Board's sentiment index rose to 68.1, which was much better than analysts had forecast.

The travel sector was one of the industries hardest hit during the recession, with both individuals and companies cutting back on their travel expenses. However, over the last year, the travel industry has been strong, a clear indicator that consumers are spending more on discretionary items such as travel, fast food, and home improvements.

We believe that the economy will continue to improve, and consumer confidence will raise along side it, but we also understand how fragile the economy remains. It would only take a couple negative headlines to bring fear back into the hearts of consumers, so we would prefer to take a cautious approach to investing in discretionary stocks.

If you believe that consumer discretionary stocks are going to continue to benefit from the recent improvement in consumer confidence, but want to hedge your bet just in case the economy stalls out over the summer, you may want to consider making a play on Consumer Discretionary Select Sector SPDR (XLY).

This consumer discretionary ETF gives you exposure to the travel industry, but also to other discretionary sectors such as fast food, retail and home improvement. Among its biggest holdings are Home Depot (HD), McDonald's (MCD), Target (TGT) and Walt Disney (DIS).

Several big names in the ETF are going to report earnings this week, including Disney, News Corp. (NWSA), (PCLN) and DirecTV (DTV). We expect to see overall strength in these earnings reports, which should help push shares of XLY higher. However, if we do see disappointing earnings from one or two of the stocks in XLY, the fact that the fund is so widely diversified will shield it from serious selling pressure.

Consider the September 45/49 bull-put spread for a credit of 30 cents. In this trade, you would sell the September 49 put while buying the same number of September 45 puts for a credit of 30 cents. This trade has a target return of 8%, which is 21% on an annualized basis (for comparison purposes only), and the trade has 11.4% downside protection.

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