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Losing the appetite for Tesco?

|Includes:Tesco PLC ADR (TSCDY)
by Mark Allen

… Across the pond analysts have been surprised by the severity of the recent food price deflation and the impact this has had on corporate earnings.

A glance at the above chart of the FTSE 100 shows that it has been a strong week for equities, with the blue chips bouncing aggressively after last weeks drop.

Risk appetite was given a healthy boost earlier in the week as Australia became the first G20 nation to raise interest rates. The Reserve Bank of Australia (NYSE:RBA) increased rates by 25 basis points to 3.25% and signaled further hikes ahead, which surprised analysts who were not expecting a move until next month.

The decision gave credence and encouragment to investors that China was exuding a healthy demand for metals. As a result, commodity prices reacted positively, which in turn has driven mining and oil related companies higher this week. Gold reached a record peak above $1050 an ounce and has gained around 20% since the start of the year.

US third quarter earnings season also kicked off on a bullish note, with results from Alcoa, the biggest North American aluminium producer, beating expectations with a return to profitability after three consecutive losing quarters.

However, equity markets have come a long way and there has been a clear change in sentiment since the second quarter, when expectations were low. The burden of proof will now be significantly higher and the risk of disappointment could create vulnerable equity markets over coming weeks.

Technical analysis highlights the sharp falls that resulted from a break of the medium term trend line last week. However, it is worth noting that the FTSE remained above the rising medium term (50 day) exponential moving average (NYSEMKT:EMA), which should offer the bulls some comfort.

The technical outlook remains skewed to further weakness, as the break of trend and close proximity to major resistance at 5200 may concern investors. The divergence between the relative strength index (RSI) and the underlying market is also worth noting, as it indicates the lack of momentum behind this week’s move.

In summary, investors are undeniably starting to question the sustainability of the recent rally and the faltering technical outlook provides further cause for concern.  However, the emphasis in coming weeks is naturally set to be on corporate earnings, with the outlook statements likely to be put under increased scrutiny.

UK food retailers have taken centre stage this week, with both Tesco (Epic: TSCO) and Sainsbury (Epic: SBRY) releasing interim results, which reflected the industry trend of slower same-store sales growth as the effects of food inflation continue to worsen.

Most of the major food retailers are showing signs of slowing like-for-like growth as the effects of food price inflation, which helped push prices and sales up, has begun to ease in recent months.

Such inflation has fallen from 9.1% in September 2008 to just 2.5% last month, eroding the increase in sales that the supermarkets have enjoyed over the last twelve months.

The results published this week quantify this data, with Sainsbury’s same-store sales, excluding volatile fuel and VAT, growing by 5.4% in it’s fiscal second quarter from growth of 7.8% in the first quarter. Tesco, whose second quarter ended five weeks before its rival Sainsbury said that same-store sales on the equivalent basis rose by 3.1% from 4.3% in the first quarter.

Both companies have highlighted that the outlook looks challenging and Sainsbury’s CEO, Justin King said he expects market growth to slow in the coming months.

Across the pond analysts have been surprised by the severity of the recent food price deflation and the impact this has had on corporate earnings. Many are starting to believe that this could hurt UK sector sales and margins more severely than consensus earnings are factoring in at present, which could lead to several downgrades over coming weeks.

This news also comes at a time when food retailers, which were viewed positively during the recession for their relative resilience, are losing favour as investors rotate into more beta stocks that enable investors to ride the upside momentum.

My preferred short in the sector for near-term weakness is Tesco, as not only have they significantly outperformed Sainsbury over the past six months, but productivity levels on food are falling. The group is now only around 12% ahead of its peers, compared with the 25-30% five years ago. They are also paying the price of its self-inflicted extra deflationary hit earlier this year when it introduced a discounted range to attract frugal shoppers.

As can be seen from the above chart of Tesco the shares have risen around 28% since the March lows and now appear to be rolling over.

The RSI has fallen rapidly and traded a fresh medium term low, which suggests that the momentum is gaining to the downside. The moving average convergence divergence (MACD) histogram, which is a trending indicator, is stepping lower and the moving averages have crossed over and are also declining, which indicates that the trend is now down.

The group’s margins are under growing pressure and the industry is returning to a period of adverse differential inflation, with costs rising faster than sales. If we combine this with the earlier analysis of the FTSE 100, I believe the shares could trade lower over coming weeks.

At the time of writing the share price is 386p and my short term opinion is negative. Near term targets are seen at 365p, 352.5p and 340p, with a stop loss marginally above the recent high at 403.5p.
Stocks: TSCDY