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Market's hottest sector may just be getting started

  • Consumer spending fell quarter over quarter in the most recent GDP report.
  • But the consumer discretionary sector was the S&P 500's best performer last month.
  • The explanation may be found in the positive earnings growth forecast for the sector.

Two signals about the strength of consumer spending appear to be sending very different messages.

On one hand, the consumer discretionary sector was the best-performing sector in April (and the second-best sector year to date); on the other, the consumer spending figure reported Friday was quite weak, with the Bureau of Economic Analysis announcing that personal consumption declined quarter over quarter in its advance estimate of first-quarter economic growth.

The seemingly crisscrossing message can be explained by separating the report's real, inflation-adjusted consumer spending figure from companies' earnings within the consumer discretionary sector, said Samuel Rines, senior economist and portfolio strategist at Avalon Advisors.

Friday's report showed the consumer slowed in inflation-adjusted terms, but companies report earnings on nominal sales — and retailers' sales have improved year over year even as sentiment around the group is rather negative, Rines wrote to CNBC in an email Sunday.

"The first quarter was not outstanding for retail sales in general, but the Census Bureau's monthly retail sales report shows sales (without adjusting for inflation) gaining about 5 percent from a year ago," Rines wrote.

Earnings are indeed expected to pick up, according to Erin Gibbs, equity chief investment officer at S&P Global.

Consumer discretionary stocks as a whole should see a "significant ramp up" throughout the rest of the year as earnings are expected to improve for the sector, Gibbs, wrote to CNBC in an email Friday. Furthermore, the sector's valuations have also risen from 20 times forward earnings to 20.6 forward earnings for the month of April alone.

"I see this as a sign of investors looking ahead and more promising return for later in 2017," Gibbs wrote.

Digging one level deeper, a few stocks have had outsized effects on the sector this year, with online retail giant Amazon being the most prominent. Home Depot and Comcast (parent company of NBCUniversal and CNBC) have also been big contributors.

The sector could benefit from rising real wage growth, Miller Tabak equity strategist Matt Maley noted.

"Real average hourly earnings have actually been coming down for the last two years, but in March they bounced nicely. If that bounce can continue, that should bode very well for consumer spending," because they are highly correlated.

The headline GDP figure released Friday reflected that the U.S. economy grew at its weakest pace in three years.

Rines expects a slight upward revision to the first quarter's reported consumption figure (0.3 percent), which he said could rise to 0.5 percent, with a return to the trend in the second quarter of around 2 percent as inflation pressures abate.

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Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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