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Since hitting their highs in March-April, the retail sector has taken a strong beating over the past several months. A significant correction was bound to happen since the uptick in the first 3 quarters in stocks in this sector was way too steep to be sustainable. However, by any stretch of logic, the current valuation levels are too low, unless you are a firm believer of a clear double-dip recession.

Let's start with the economy - as i opined in my last article, there are simply no clear indicators of a double dip - despite the fact that employment stats would remain depressing for quite some time. Recent indicators on home sales, manufacturing and retail have been very mixed too, indicating a slow but choppy recovery. Neither the government nor the private sector can afford a double dip at this point, and given the speed with which stakeholders have acted to quell any fears of a slip-back into recession, there is little reason to worry about a double-dip actually happening. Moreover, many real indicators are so depressed that there is not too much room to move down from here. Given this, I would put my bets on at least a minor-to-moderate rally in the retail sector over the next quarter, especially with back-to-school and holiday seasons perking up sales.

In fact, August numbers from several retailers beat analyst expectations, helped by increased promotions, and a pickup in back-to-school sales. Overall same-store sales (Retail Metrics index culled from 30 retailers) rose 3.5% as against an analyst expectation of 2.8% - this is the first time since Q1 that there has been a positive surprise. Several retaliers had positive same-store sales surprises - from Costco (NASDAQ:COST) (7%) to Nordstrom (NYSE:JWN) (6.3%) to Zumiez (NASDAQ:ZUMZ) and Wet Seal (WTSLA), numbers were good pretty much across the board, though not for all names.

September results will be critical to guage the overall trend, as the back-to-school season is the next biggest period after the holiday season, and is often a good barometer of Q4 peformance. Just looking at the lines in front of retailers like ANF, M, and JCP, it is hard to doubt the fact that it is going to be a better Q3 and probably an even better Q4. My wife went in for the Macy's one-day sale today here in Boston, and from her words, it feels like it's Thanksgiving weekend already - clearly there is enough steam left in consumer spending to present positive surprises on currently depressed expectations.

Some names are interesting, specifically: American Eagle (NYSE:AEO) and Aeropostale (NYSE:ARO) are decent picks to ride this season, given current valuation levels. However, among all the good picks, i would put my money on JCP and KIRK.

JCP is trading close to its 52-week low at about 21, and not too far from its 5 year low. At a P/E of ~16+, with its value-for-money merchandise positioning, i do not see much of a downside. If initial back-to-school trends are an indication (August sales up 2.3% as against an analyst estimate of 1.6%), it should see reasonably healthy Q3 numbers and a good Q4. Given the choppiness of the market and the high stock beta (1.7), I would not bet on near-term options though...I would either go long on the stock or Jan '11 options. From a timing perspective, note that Q3 results will be out in mid-November.

KIRK is trading at 12+, close to its 52-week low of ~10 and far below its high of 25.3. Given the spread and uniqueness of the merchandise they carry, I would jump on this stock at its current P/E of sub-7. The stock has been hammered badly ever since May primarily because same-store and overall numbers failed to keep the abnormal growth trend shown over the previous year. Q2 2010 revenue numbers were only 2% higher Y-o-Y and same-store numbers were only 1% higher. It was a case of expectations going way above normal, and a correction to reflect reality - however, the downward correction has been clearly overdone, and I would bet on a level of at least 16-17 by Q4. As mentioned earlier, i would rather go long on the stock or longer-term options as against near-term options. Again, from a timing perspective, note that Q3 results will be out in mid-November.

Disclosure: Long on KIRK. Will be long on JCP and probably AEO shortly.

Source: Fishing for Value in Retail - Two Especially Good Picks