A record rise in this stock-market sector may not spell doom for investors.

By Joseph Adinolfi

Here are 2 reasons why defensive consumer-staples stocks are rallying

The typically sleepy consumer-staples stock sector has been having a moment lately. Should investors be worried?

The sector XX:SP500.30, known as a defensive play, is coming off a stretch of outperformance compared with the S&P 500 SPX, while an ETF that tracks the sector closed in record territory for the first time in more than two years on Monday. Meanwhile, strong earnings reports and a major acquisition deal have added to a flurry of activity in the space.

Last week, privately held Mars Inc. announced it had agreed to buy snacks giant Kellanova (K), the maker of Pringles and Pop-Tarts, for around $36 billion.

See: Mars-Kellanova deal likely to avoid antitrust hurdles and open door for more M&A

But rather than being a harbinger of tough times ahead for the U.S. economy, some see other explanations for why these stocks have taken off.

Recently, consumer staples have found themselves at the intersection of two of the market's most important trends. First, earnings from consumer-facing companies have been providing increasingly critical insights about the state of the economy. Meanwhile, stocks that might benefit from lower interest rates have suddenly found themselves back in vogue.

Even after last week's retail-sales report helped assuage concerns about a slowdown in spending, investors will be keeping close tabs on corporate earnings due out over the next week or so as they search for more clues about the state of the consumer.

Results that send a strong, positive signal could help lift the broader market, as investors saw when Walmart Inc. (WMT) bested expectations last week, Steve Sosnick, chief strategist at Interactive Brokers, told MarketWatch.

Target Corp. (TGT), Dollar Tree Inc. (DLTR) and Dollar General Corp. (DG) are all due to report this week or next. Investors are eagerly awaiting numbers from each.

"I think there's a huge focus on the health of the consumer, and where the consumer is gravitating toward," said Erin Lash, director of consumer equity research at Morningstar, in an interview with MarketWatch. "Especially by demographic - are we seeing pressure on the low end, middle or the higher-end consumer? That is a topic that has been in focus across a large swath of firms throughout a host of sectors."

Bad times for the economy are often better for staples

Consumer-staples stocks typically benefit during the early stages of an economic slowdown, Sosnick said. Put simply, while consumers can more easily put off major purchases like vacations and new cars, cutting their spending on essentials like toothpaste and food is more difficult.

Furthermore, retailers included in the sector, like Walmart and Costco Corp. (COST), typically benefit as wealthier consumers start to seek out bargains. Investors have seen some signs of this in recent Walmart earnings reports.

"During the initial parts of a downturn, companies like Walmart and Costco get more affluent shoppers spending more money in their stores," Sosnick said.

Recent economic data and earnings reports have suggested that the U.S. economy may be starting to cool after the Federal Reserve aggressively hiked interest rates in 2022 and 2023. But as of now, few see signs of a recession ahead.

If not a recession, then what is driving the outperformance of consumer staples? According to Callie Cox, chief market strategist at Ritholtz Wealth Management, they have been caught up in growing demand for dividend stocks and other interest-rate-sensitive names as traders brace for the Fed to cut interest rates.

Some of these include fellow defensive areas like utilities XX:SP500.55, Cox noted. But financial stocks XX:SP500.40, hardly immune to downturns, have also done well.

"Even though they are traditionally defensive stocks, we've seen investors treat [consumer staples] as a more offensive strategy as rate cuts come into view," Cox told MarketWatch.

"Now is a good moment to realize that defensive stocks aren't defensive in every environment," she added. "Sometimes, they can be opportunistic."

Fresh record highs

A popular ETF that tracks the consumer-staples sector finished in record territory on Monday for the first time since April 2022, according to Dow Jones Market Data.

That followed a stretch of outperformance that peaked earlier this month, when the sector beat the S&P 500 by 9 percentage points over a stretch of 20 trading days - its strongest relative showing since April 2022, as well.

In the past, when consumer-staples stocks have done comparatively well, it has often coincided with difficult periods for the broader market. For example, their previous record highs from April 2022 occurred at the beginning of a rocky stretch for the broader market. Six months later, the S&P 500 was down more than 17%.

Something similar happened as the dot-com bubble collapsed in 2000. That year, the sector gained more than 24%, while the S&P 500 fell more than 10%. But consumer staples soon joined in the swoon, nearly keeping pace with the S&P 500's declines in 2001 and 2002.

Consumer-staples stocks finished higher on Monday, with the Consumer Staples Select Sector SPDR Fund XLP gaining 0.3%, to $80.78. The S&P 500 rose by 54 points, or 1%, at 5,608.25, while the Nasdaq Composite COMP rose by 245.05 points, or 1.4%, at 17,876.77. The Dow Jones Industrial Average DJIA rose by 236.77 points, or 0.6%, at 40,896.53.

-Joseph Adinolfi

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08-20-24 0700ET

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