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While some retailers managed to join in Wednesday's post-fiscal cliff market rally, many big names showed declines even as the broader market gained 2%. I believe this merely foreshadows continued weak performance for retailers through 2013. While Congress managed to avert a disaster for the time being, current U.S. fiscal policy is unlikely to result in meaningful economic growth. Consumer spending will be particularly sluggish in 2013, and retailers dependent on discretionary spending will be hard pressed to maintain profits at 2012 levels, let alone grow them. I think that there are numerous potential short targets in the sector, and few if any stocks worth buying at this point.

The biggest drag on retail spending comes from the expiration of the 2% payroll tax reduction that has been in effect for the past 2 years. Individuals earning $50,000 will take home $1000 less in 2013, and those earning $100,000 will have $2000 less in take home pay. All in all, the government will "save" about $120 billion by ending this tax cut, and most of that amount will come out of consumer spending. Any way you slice it, a flat 2% increase in taxes on income up to $113,700 will impact spending habits for all but the very richest Americans. Meanwhile, the top 1% or so of taxpayers will face a cap on itemized deductions and a significant increase in the top tax bracket to 39.6%.

Additionally, government spending will be cut back over the course of 2013, which will create another drag on the economy. Tuesday's legislation only delayed the "sequester" (a series of automatic, across the board budget cuts) for two months. Republicans in particular are sure to demand significant cuts to current and future spending, come February, to replace the sequester. These cuts will begin to exert a dampening effect on the economy by the time the 2013 holiday season rolls around.

Moreover, consumers still face rampant uncertainty as Republicans and Democrats appear to be gearing up for another big battle over the next two months. The U.S. government has already reached the debt ceiling, and Congress will need to raise the borrowing limit by the end of February or so to avert a default. This coincides (approximately) with the timing of the sequester, giving Republicans significant leverage to force cuts to spending and entitlement programs. However, President Obama has stated on multiple occasions that he is not willing to negotiate over the debt ceiling or have it held hostage to other goals. The situation thus appears set for another showdown that drags out to the last minute. Even if the Republicans and Democrats ultimately find agreement, the current uncertainty will not put consumers in a spending mood. Recent reports have suggested that holiday spending was weaker than initially forecast, likely due to uncertainty regarding the fiscal cliff. Over the next few months, there will be continued uncertainty, to go along with higher tax bills. This is not a recipe for retail sales growth.

Other pundits have argued that factors such as lower unemployment and an improving housing market will come riding to the retail sector's rescue. However, job growth has been relatively anemic this year; most of the decline in the unemployment rate can be attributed to discouraged workers leaving the labor force. Government payrolls are likely to shrink substantially in 2013, which will offset much of the growth in private payrolls. Meanwhile, higher effective tax rates will exert a larger impact on retail sales than improving home values (higher home values may actually hurt the large number of consumers who rent). The housing recovery and general economic recovery will not provide enough of a boost to consumer spending to make up for the drags of higher taxes, lower government spending, and consumer uncertainty.

Department stores appealing to the middle/upper middle class such as Macy's (M) and Dillard's (DDS) are likely to be particularly hard hit, because they sell discretionary items, and their customers will have significantly lower disposable income next year. Both companies have shown strong profit growth in recent years, but I expect dramatically slower earnings growth (or even declines) in 2013. This would inevitably weigh on the share prices. As I have discussed before, Dillard's seems to be in a more precarious position, and is a viable short candidate.

Discounters such as Wal-Mart (WMT) and Target (TGT) may fare somewhat better, because they sell more basic necessities. Moreover, some consumers may trade down from more expensive retailers to discount stores in order to save money. Amazon.com (AMZN) may also benefit from this trend, as it tends to be cheaper than its bricks and mortar competitors. That said, it is likely to be hit hard by a slowdown in spending on consumer electronics, a segment which has been one of the biggest contributors to Amazon's revenue growth recently. Moreover, the company trades at a sky-high forward P/E of nearly 150, making it a viable short candidate.

For investors who want some exposure to retailers, Wal-Mart is probably the best pick for 2013, but I think it is probably wiser to avoid the sector altogether until valuations and expectations come down.

Source: 2013 Will Be Ugly For Retail Stocks