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by Brian Sozzi

In what is a 24 hour news cycle, extracting the message of the market can prove to be a perilous exercise. Coming into 2011, market mavens waved their wands over internal spreadsheet documents, conjuring up scenarios that would bring the S&P 500 higher by 5% to 15%.

I was hard pressed to find an I-banking economist negative on the market. Who could blame these guys and gals? Money continues to flow easily from the Fed until it doesn't (some $375 billion remains under latest QE), no true hard landing is expected out of emerging economies transitioning from loose to tighter monetary policies, and the U.S. jobs engine is allegedly set to rev up to create 150K plus in non-farm payrolls a month despite the baton being passed to the private economy from government induced growth.

On the other hand, there are risks out there lurking, which certainly have the power to derail the bull thesis on the market. Overly indebted states, the impact of inflation on final demand, and of course the long-run viability of the EU are but a few of the commonly called out risks that have basically gone unappreciated, or underpriced in valuations, to start 2011.

There is no hiding the fact that consumer discretionary stocks, in particular retailers, enjoyed a hot streak in 2010, buoyed by a returning U.S. consumer, deflationary merchandise bought in 2009 and sold in 1H10, and the continued specter of the productivity miracle. That said, we moved to pare down our retail sector positions beginning on Cyber Monday. Thus far, the strategy has worked out well as the disappointing batch of December same-store sales results, less than enthusiastic 4Q10 pre-announcements, and mixed messages from ICR last week has sent the S&P Retail Index below key support on the chart. I think the pullback amidst the broader market's lingering bullishness is indicative of the following:

1. A more realistic view of the U.S. consumer recovery. When Family Dollar (NYSE:FDO) reports store traffic was up 7% in the quarter it's a sign that low income consumers are struggling with higher prices on staples, gasoline, and job prospects. Until traffic at dollar stores begins to soften, how can we say with a degree of confidence the consumer is alive and kicking emphatically?

2. A more realistic view of the earnings power of retailers in 2011 given a choppy consumer spending environment where price resistance remains and costs are moving up. Price resistance, promotions, and increased costs are not a tasty combination for market sentiment.

With investor sentiment on the retail sector having turned ever so slightly (I almost feel a pause in the tape), it's now very critical to read the market's tea leaves. Fortunately, we have been privy to a torrent of holiday sales updates following the December same-store sales releases. Market reaction cumulatively has been negative; positive news (guidance raise) was met with profit taking and unfavorable news was met with a slamming of the stock price. The market is suggesting that a certain level of sales and earnings growth is priced into valuations and any slight deviation to the collectively held wisdom will be dealt with accordingly.

4Q10 earnings calls are right around the bend, and in the type of tape we are now experiencing, cautiousness is the name of the game. I recommend employing two strategies if one is inclined to add long positions from the sector. One, is to go long what we perceive as turnaround names that are priced as such; in order to make the grade, we have to have garnered knowledge that hints at improved fundamentals in the near future. Two, is to go long names where 4Q10 earnings will surprise materially to the upside, creating upward earnings revisions to 1H11 consensus. Either way you slice the cake, it's a different ballgame picking stocks in the sector as opposed to the start of 2010.

Market Speak

Sears Holding (NASDAQ:SHLD)-January 11
* Stock finished the trading session yesterday up 6.3% on FY guidance being taken to $3.39-$4.12 per share versus the $3.09 per share consensus. However, there was a lack of quality underlying the guidance raise. Sales were far from robust in big ticket categories (layaway drove Kmart), and I think the guidance beat was a function of a tax benefit. Sears shares have retreated since the release.
* Key notes: Soft sales in big ticket departments, layaway increase at Kmart.

Talbots (NYSE:TLB)-January 11
* Stock was hammered by 18% on same-store sales tracking below guidance by 700 bps. The loss per share range of $0.15-$0.19 was beyond the consensus loss per share of $0.02.
* Key notes: Poor customer response to spring transitional merchandise.

Furniture Brands (FBN)-January 11
* Stock finished lower by 6% on a 4Q10 top line miss and a worrying amount of asset related charges.
* Key notes: credit may be flowing a bit looser, but furniture sales continue to lag the improvement in demand elsewhere in retail.

Tiffany & Co. (NYSE:TIF)-January 11
* Raised guidance to $2.83-$2.88 per share versus the $2.78 per share consensus (below some analyst estimates). Stock declined 4% on the day.
* Key notes: slowing revenue growth rates relative to 3Q10, lower end collections mixed performance.

Liz Claiborne (LIZ)-January 7
* Range of excuses for tailoring of 2H10 guidance. Stock was crushed by 13% on the day.

Source: Reading Market Tea Leaves: Retailers Edition