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Investors In Fine Jewelry Stocks Face Volatile Business Returns

|Includes:SIG, Zale Corporation (ZLC)

Investors in mid market fine jewelry stocks like Zale (NYSE:ZLC) or Kay Jewelers (NYSE:SIG) may face higher risk for the remainder of 2012 AMD 2013 AS fine jewelry and watch sales weakened during the first half of 2012 according to Ken Gassman, an analyst at 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 sales dynamics in the 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 NGO's, 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 styled resources. In the product's 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 risky start.

Apparently unplanned and certainly undercapitalized, the program to position and market genuine, non-natural, diamonds is in the effort's 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 products intangible association with love, romance, and marriage.

Still, there is a certain inevitability that commercial opportunity and marketing ingenuity will eventually intersect, releasing the product is potential to return profitability to the diamond jewelry business and reframe the retail jewelry industry. 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, increased competition from substitute products, and growing consumer confusion about diamond values and cultural norms.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: ZLC, SIG