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By Brian Sozzi

The winning strategy for much of the second quarter has been to long consumer staples and other "defensive names." Pick your poison as to the macro reasons supporting this flight to perceived safety. I say perceived because as we are fully aware in a correction, those in the lowest rung of the capital structure will experience losses no matter if the name is Proctor & Gamble (NYSE:PG) or Abercrombie & Fitch (NYSE:ANF). That being said, of the 90 pure play retailers I track on a portion of my trading screen, a majority of the stocks remain mired in bearish sentiment:

  • 38% trading below their 200-day moving average.
  • 9% trading below their 100-day moving average, but above their 200-day moving average.
  • 7.7% trading below their 50-day moving average, but above their 100-day moving average.
  • 29% trading above their 50-day moving average, but only 10% I would quantify as "safely" above the moving average.

Consensus estimates on retailers were dutifully slashed following downbeat 1Q11 earnings calls, applying the first round of excess being squeeze from analytical models. High costs of doing business, bountiful inventory, and scattered buyers of the stuff sitting on the sales floor were the igniter fluid to the re-pricing of the sector. Since then, the second round of earnings estimate revisions have generally not begun, but I think they will shortly, potentially post June same-store sales release day. Inventory remains elevated and the second quarter has been noticeably discount heavy, while costs are locked in at peak rates from earlier in the year. Note that discounting is a factor of consumer demand failing to live up to the expectations of overly optimistic management teams.

The report from Nike (NYSE:NKE) is very important to sentiment on consumer discretionary stocks. Remember, Nike missed consensus earnings by $0.04 and disappointed some on the Street with its future orders print on its last afterhours earnings report card, sending the stock sharply lower on the next trading day. In hindsight, the company sounded the alarm bell with respect to looming cost inflation, and set the tone for the ensuing weeks of trading in the retail sector (profit-taking).
Possible Scenarios this Time from Nike's Report:

  • Best: The company beats on earnings amid reduced market expectations and benefits of price increases and emerging market demand. Management continues to be cautious on the outlook for costs, but signals that first signs of moderating cost inflation have emerged (cotton, transportation, etc.). That commentary would provide those sitting on the sidelines waiting to move back into the sector with visibility into an improved run rate of earnings, so bottom feeding picks up in beaten down best of breed names.
  • Worst: Nike misses on earnings again, saying price increases are lagging the inbound costs it continues to experience. Continues to sound cautious on the cost outlook, not seeing any margin relief following input prices off their peaks. Goes onto note that consumers have resisted some of the recent price increases through trading down to cheaper styles (buying a pair of Nike's at Kohl's instead of Finish Line) or refraining from purchases in the near-term. In this outcome, consumer discretionary stocks are unlikely to catch a bid.

Is there an Impending Retail Earnings Bonanza?

At the very basic level, to justify a higher valuation on a particular stock one has to have conviction that the market has missed something and your modeling is correct. Unfortunately, I am unwilling to play Superman, or the hero, on retail names given volatile month to month same-store sales trends, weakening personal spending (since February), and general margin considerations. However, if retail stocks are going to shift from a state of depression it will be in the middle of 3Q11, barring a swift downdraft in consumer spending. The relief on costs by 4Q11 is not a farfetched thought as it was a little tidbit that Gap (NYSE:GPS) tossed out there on its 1Q11 earnings call. Comments may be made on the topic in the upcoming earnings season for the sector. Therefore, we would be left with the following investment thesis:

  • Lowered market expectations.
  • Costs moving sufficiently below early in the year peaks.
  • Significant leverage in the economic model due lower costs, global price increases, and meaningful efforts to find new sources of materials and to re-design products to include fewer inputs.

In my view, the inclusion of structural factors (shifting production and product re-designs) will eventually be accounted for in stock valuations, again perhaps in front of the holiday season.

Source: Consumer Discretionary Still Not Feeling the Love