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Since I wrote about JC Penney (NYSE:JCP) in September 2010, when it was trading at 21, it's been up by close to 70%, currently trading at a P/E of over 22. JCP is perhaps a good indicator of how most retail stocks have performed over the past 6 months. A mild pick up in employment and the apparent release of pent-up demand have driven consumer spending over Q3 & Q4 2010, and this has in turn propelled retail stocks in to multi-year highs.

Looking at the fundamentals, economic growth has been reasonably steady over Q2-Q4 2010, due to sustained growth in the manufacturing sector (led by export demand) and a pickup in the financial sector from multi-year lows. Unemployment rates improved mildly to ease below 9%; however we need to note that there has not been a sustained rise in employment creation. The housing market meanwhile has touched further lows - with over 30% of sales being pure-cash and over 40% being distressed properties as of Feb 2011. It will take a long time for prices to recover, and for the 9 months+ inventory to inch down to levels that signify price stability. Continued credit worries in Europe, food-price driven inflation in emerging markets and the situation in Japan are not contributing a lot to positive momentum.

Given this backdrop, it is difficult to justify the current levels at which many retail stocks are trading. If we look deeper, we can see that the momentum around retail stocks has in fact slowed already - the S&P Retail Index is up only 1.4% for Q1 2011, after a 10%+ rise in Q4 2010 and a close to 20% advance in Q3 2010. The index is also lagging the 5.6% Q1 2011 rise for the broader S&P (NYSEARCA:SPY) index.

I feel the sector is over-valued at this point and is highly susceptible to negative events affecting the broader market.

I would exit or go short on a few in particular:

  • JCP: a pull back to sub-30 might be possible, bringing it to a more sustainable P/E of ~18
  • Abercrombie & Fitch Co. (NYSE:ANF): Trading at a P/E of 35, with close to a 100% rise after late 2009. It's indeed difficult to bet against a name like ANF, but the current levels are pretty unreasonable

On the other hand, some retail picks like Aeropostale Inc. (NYSE:ARO) and American Eagle Outfitters Inc. (NYSE:AEO) should see positive momentum compared with the rest - these are possible value picks at this point. However, there are not many of those in the retail sector.

On the whole, it is difficult to expect the sector to sustain the momentum over the past few quarters, and any pull back in the market presents significant risks for several retail stocks.

Source: Are Retail Stocks Losing Momentum?