The markets were greeted today with an economic report that disappointed even negative expectations.  Retail sales for the month of December dropped 2.7% which was basically double the consensus expectations.  Although the report is being heralded as “the worst holiday spending in decades,” it is helpful to put some of the figures into perspective.

Retail sales make up a very broad category and most headline readers probably missed the fact that the majority of the sales drop was due to lower gasoline prices.  Without factoring in gasoline and the automobile category, retail sales only dropped 1.5% for December.   This is still quite a large drop, but it helps to put the numbers into perspective.

Unfortunately, these numbers aren’t set in stone, as the statistics from November and October were adjusted lower as well.  It now looks like November retail sales declined by 2.1% instead of the previously reported 1.8%, and October saw a slide of 3.4% compared to the previous 2.9% level.

There are those out there who believe in conspiracies to make things look better than they are initially.  Then once the sting of the headline has passed, the figures are revised lower and hopefully slid under the radar.  I’m not one to see a shadowy figure behind every tree, but it is interesting to see that the information has a trend of getting worse.  For whatever it is worth, December marks the sixth consecutive month that we have seen weaker sales.

According to the Wall Street Journal, much of the weakness in consumer spending is due to three factors:

1. A high level of debt.   Consumers are essentially maxed out on much of their available credit.  Since the financial institutions are unwilling to lend much additional capital, and home equity loans are not nearly as available, this level of debt reduces the amount of flexibility consumers had for holiday shopping.
2. Weak Asset Prices.  Most households have a large portion of their wealth tied up in their personal residence.  As home prices decline, consumers “feel” poorer and are unwilling to spend as lavishly.  Also as mentioned under the debt category, a lower asset value means home equity loans are unavailable because many consumers simply no longer have equity in their homes.
3. Fears of Layoffs.  I’ve seen plenty of my friends or neighbors either experience layoffs, or see cuts in compensation.  Whether this happens to you or not, you likely see the same issues in your neighborhood.  While unemployment is still much lower than depression status, the fear of loss of income has a very negative effect on spending.

So what do we as investors do with this data?  You’re probably guessing that I’m not going to tell you to hit the “panic” button.  It simply doesn’t make sense to completely bail out of the market at these levels.  But I do think you have to be very strategic in your tactical approach.

• Cash is an investment.  While long-term, inflation will eat away at a large cash balance, it makes sense to have some dry powder until we get a better indication that growth is coming back
• Selective Short Positions.  Many of my short ideas are already trading to levels where the risk of a rebound prevents shorting.  However, a few categories (For-Profit Education, Transaction Processing, and certain Niche Retailers) still have attractive short attributes.  This portion of your investment account can have the goal of trading profits (aggressive) or simply to offset risk from long positions (a more conservative approach).
• Careful Investment in Strategic Sectors.  While late 2008 saw nearly every sector getting pounded, we are seeing pockets of strength in particular industries.  Shipping, Alternative Energy, and Infrastructure come to mind as beginning positive trends.  There will be other categories emerging in the coming months as well.  But success requires careful study, proper timing, and a healthy dose of patience.

So in short, yes the economy is difficult.  Headlines make for hand-wringing and fear.  But fear does not help in sound investment decisions.  As always, have a plan that is tested, implementable and one that you can be comfortable sticking with for the long-term.  Exercise patience and risk management.  And in the end, fundamentals will eventually be reflected in the prices of your investments.  If you do your homework right – the returns will work themselves out.

Best of success to you in this turbulent market,
Zach