Retail Stocks Appear Ready to Fall

It’s finally beginning to happen… After spending the last three months mounting some of the most impressive single stock rallies seen in decades, a few retail stocks are beginning to roll. And that roll could lead to some impressive profits for ZachStocks traders willing to take the unpopular side of the upcoming trend.

The Rise and Fall of Retail Stocks

Much of the recent rally in retail stocks stems from the bargain basement prices many of these stocks started out with early this spring. As investors fretted over the “end of the economy as we know it,” stocks of all colors, shapes and sizes were liquidated at just about any price. This mass selling actually set the table for a sharp rebound in many sectors once the situation began to stabilize.

Rallies from the March lows were not necessarily based upon the fact that “things were getting better” as much as a relief from investors that the financial system did not completely fall apart. As the economic picture continued to function (although one could certainly argue that we are limping along instead of making strong strides), opportunistic investors began to search for good values among the wreckage of retail stocks.

These stocks were not too hard to find as there are plenty of companies that continue to operate profitably despite reduced growth estimates and a generally weak consumer. As these bargains were picked up by investors in March and April, the buying soon resembled a feedback loop where strength in the names reinforced investor confidence and drove further buying. But while buyers in March had legitimate fundamental valuation on their side, buyers in many names today seem to be simply piling on to the momentum with little regard for valuation.

Fundamental Spending Changes

It is abundantly clear that all retail stocks rely on consumer spending to varying degrees. While different types of consumers frequent different classes of retail companies, the bottom line is that all are dependent on at least one subset of the population to take out the checkbook or credit card in order to make purchases.

Unfortunately at this point it is becoming harder and harder to find those consumers with the ability or willingness to make the same level of purchases seen earlier in this decade. There used to be a relatively sound argument that the high end retail stores would survive a recession due to the fact that the rich always have cash to spend. However, the current recession has been difficult for all classes of spenders as evidenced by layoffs from Manhattan to Detroit. In fact, it now appears that retail companies catering to the affluent are in more dire straits as the wealthy clients “trade down” to more modest clothing, restaurant, or leisure offerings while lower-end customers are simply learning to do without some purchase that normally would not be considered discretionary.

Recently, an economic report came out showing that while personal income had begun to tick just a bit higher, consumers spending continued to decline. The result was an increase in the savings rate and we are likely seeing only the beginning of this trend.

For years, consumers had many choices when it came to funding purchases. Credit cards were usually the liquidity option of choice as teaser rates and high available balances made spending painless and easy. Even consumers who borrowed above their means were usually bailed out by the ability to refinance their house pulling equity out to reset the system and begin accumulating credit card debt again.

However, now that many of these channels are no longer available, consumers are first of all forced to stop spending beyond their means. This trend is easy to understand and accepted by most thoughtful investors. However, a less visible trend will be for consumers who no longer have access to a “safety net” of home equity or available revolving credit to begin building emergency funds in the form of savings accounts, CDs or other short term deposit instruments. The result will likely be that even if employment begins to turn higher (which has not happened yet), the level of spending will remain low. That’s not good news for an economy that has typically relied heavily on consumers for growth.

Investments Poised to Fall

The positive feedback loop we mentioned earlier is now in danger of stalling. Friday we received an employment report which was supposed to be “good news” in that it was less dire than economists had been expecting. The market gapped higher initially but failed to hold any of its gains into the closing hour. Overbought markets failing to rally on good news (especially on Fridays) can often spell doom for a positive trend.

Not all retail names are vulnerable at this point, but there are several relatively high-priced stocks which should decline and offer sharp gains for traders who are willing to step against popular opinion, and who have the ability to time their trades correctly.

Tiffany & Co. (TIF) has seen declining earnings the last two quarters as sales have dropped by more than 20% on average. The weakness was primarily due to tough spending in the North America region. The company is seeing inventory levels increase which could spell trouble down the road. Expensive inventory sitting idle while the company manages a high debt level is certainly not a recipe for success.

Chipotle Mexica Grill (CMG) has climbed significantly while sales growth has actually been stalling. The stock holds a growth stock multiple but at the same time that growth is being called into question. If inflation becomes an issue in future quarters, it could sharply compress multiples and the multiple on the stock would also see weakness.

Green Mountain Coffee Roasters Inc. (GMCR) has bucked the trend so far but may be running out of steam. The specialty coffee retailer is trading at more than 60 times this year’s earnings and while growth is expected to be positive in the years to come, that multiple leaves investors vulnerable to any disappointing news.

There are plenty of other names which could be vulnerable to an upcoming decline in retail stocks. One of the most important issues to look at is whether the stock is trading at a high multiple relative to the expected growth. A more difficult but equally important measure would be to determine whether growth expectations are truly legitimate or not given the macro picture for consumer spending. When a good target has been identified, timing is important as the stock should begin trading lower and the broader market should be following a similar trend. Shorting stocks in this market can certainly be risky but the potential returns are quite attractive.

Disclosure: Author has a short position in GMCR.