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Investors in fine-jewelry retail stocks like Zale (ZLC) and Kay Jewelers (SIG) face volatile returns as fine jewelry and watch sales weakened during the first half of 2012, according to Ken Gassman, senior analyst for Idex Online. Over the period, monthly growth in fine jewelry and watch sales declined from just over 8.0% in the first quarter to slightly less than 3.0% in the second quarter of 2012.

For the first six months, jewelry sales increased about 5.5%, while better watch sales increased approximately 4.5%, using U.S. Commerce numbers. Over all, fine jewelry and watch sales increased about 5.3%, which was consistent with U.S. retail growth of 5.4% (ex-car sales), according to Gassman. That performance was significantly off the 2011 pace, where fine jewelry and watch sales increased about 12.9% in December 2011.

One view is that jewelry demand has declined as economic growth has slowed in the first half of 2012, but that explanation over simplifies the industry dynamics, driving the U.S. jewelry industry. Cumulatively, most, if not all, of the jewelry sales increase in 2011 can be attributed to inflation in diamond and precious metal prices. Indeed, with retail price increases exceeding 9%, real jewelry sales growth in 2011 was likely negative.

Likewise, with prices more than 9% higher in stores at the beginning of 2012, total jewelry growth in the first half of 2012 have been negative too. That is a material difference between real GDP growth of about 4.1% in the fourth quarter of 2011 or 2.0% or 1.7% in the first and second quarters of 2012 respectively. Still, there is the optimism that better days are just around the corner, despite past and emerging structural problems in the U.S. jewelry industry.

Underlying the decline of U.S. fine jewelry industry is the demise of the diamond segment of the market. Since, 2001 when DeBeers abdicated the company's historic role as the global market maker for diamonds, both the rough diamond mining business as well as the polished diamond market has been in turmoil. Driven in part by the ineffectiveness of the free market mechanism to match consumer demand to the mix of size, shape, and quality of diamonds available and partly because of distorted credit markets, diamond prices have increased far in excess of the products real underlying demand. Granted, industry spin insists global demand for diamonds is growing, in spite of the higher prices. However, that does not explain the sale of the DeBeers' residual interest in diamond mining in 2011 or the de-emphasis or liquidation of diamond mining business segment by the remaining diamond mine owners. Closer scrutiny suggests the diamond business is viewed strategically as a cash cow by both private owners and NGOs, which will eventually lead to further declines in consumer demand and significant growth problems for retail jewelers, especially in the U.S. And that is not the worst of it.

While commodity sellers and government entities drive cash out of the existing diamond markets, new markets for substitute diamond products are emerging. None more so than the synthetic diamond market. A fundamental driver in DeBeers' decision to sell the company's rough diamond reserves in 2001, near colorless, synthetic diamonds are now available in the market through both legitimate technology owners as well as gray market resources.

Still in their infancy, these genuine, non-natural diamond substitutes will reshape the retail diamond business. However, how fast that transformation takes place depends in large part on how the product is marketed, which, admittedly, is off to a slow and uncertain start.

Apparently unplanned and certainly undercapitalized, the program to position and market genuine, non-natural diamonds is in its infancy. Now, marketed over the Internet by at least one proprietary technology owner, the potential sale of synthetic diamonds by corrupt sellers to defraud legitimate dealers or deceive consumers has gotten more publicity than the real benefits of the product. Not to mention the confusion the passive marketing efforts has added to the consumers' growing confusion about diamonds' tangible value as well as the product's intangible association with love, romance, and marriage.

Now, the JCK reports that ShopperTrak forecasts holiday sales will rise about 3.3%. If fine jewelry sales continue to mirror general retail, continued negative real growth in fine jewelry sales is about the best investors can expect. That is especially so, since the average gold price is about 4.6% higher than last year and is likely to further increase as QE3 propels commodity prices higher, according to Wall Street Cheat Sheet and Kitco, a leading precious metals dealer.

Monetary policy may also drive diamond prices higher during the fourth quarter, which could mitigate the average decline in better diamond prices year over year of about 6.6%, which has done little to stimulate market demand, except for maybe Blue Nile (NILE), which would be a net loser from higher diamond prices. In short, macroeconomic has put the industry back into play again, meaning investors should consider revising strategies.

For example, negative real growth in the fine jewelry segment suggests the industry is losing real market share to other categories. Therefore, medium-term investors should focus on real-market-share growth in luxury product segments. Likewise, short-term traders may want to reconsider employing the bubble strategy to drive stock returns, i.e., it does not seem to matter that a stock's price is irrationally high; it only matters that the stock can be sold for an even more irrational price tomorrow.

However, the biggest returns and risk may go to the venture capitalists and mezzanine debt providers that recognize the U.S. fine jewelry business is undergoing a major restructuring and support those emerging businesses and seek out new entrepreneurs that are most likely to both enable those changes and develop strategies to create unique and sustainable competitive advantage.

Fortunately, in the U.S., there continues to be a certain inevitability that commercial opportunity and marketing ingenuity will eventually intersect to reframe the retail jewelry industry for 21st-century consumer values and norms. Meanwhile, about the most many jewelry owners and real investors in the fine jewelry business can expect is volatile business returns because of further diamond mining fragmentation, declining industry investment in building the market, and increased competition from substitute products.

Source: Investors In Mid-Market Jewelry Stocks Face Uncertain Returns