Over the weekend there was a very insightful Baron’s Article entitled “They Shopped ‘Til They Dropped.”  The bottom line was that the recent rally in retail stocks may be sending a false signal.  Rather than indicating an improving environment for individual consumers, the rally likely has only proven that investors are more willing to take risk on a sector that remains fundamentally weak.

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Bullish investors have recently pointed to earnings reports by many strong retailers which have shown growth in profit and higher management guidance for 2009 and 2010.  But the higher profits are largely a function of costs being cut instead of an actual increase in revenues.  Over the course of several quarters, this kind of cost cutting will only be able to reduce expenses by so much before cost elimiations cut into profitable functions.  At the same time, the increases in unemployment turn around and affect the number of willing buyers on a macro level.

Barron’s lists four significant challenges which will affect consumer’s ability to buy – and in turn retailers ability to show growing profits.

1. Excess Borrowing – Credit card companies may have stopped sending out as many unsolicited applications, but the damage has already been done.  The US consumer is now deeply in debt and struggling not only to pay down the principal amount, but many consumers are now having difficulty servicing interest payments on these balances.
2. Higher Taxes – An aggressive administration has been pushing for more entitlement programs which will no doubt increase the taxes on working Americans.  The tax burdens (whether borne by those with incomes under $250k, over 500k, or anywhere in between) will have a significant effect on discretionary spending.  With dollars being taken out of private pockets and put to work in government programs, it is unlikely we will see any improvement in spending habits for quarters to come.
3. Lower Wages – Sure the minimum wage may have increased, but as a general rule the wage level continues to be pressured.  Factor in the potential for significant inflation and the real value of wages could become much smaller.  Consumers will lean ever more towards purchasing only neccesary items which will be very damaging for retail companies who cater to a more affluent (or even just middle class) lifestyle.
4. A Growing Need to Save For Retirement – Not only have retirement accounts, invesment accounts and pensions been hit hard by the bear market, but home values have also decreased sharply.  Many consumers approaching retirement had counted on the value of their home as serving a significant role in funding retirement.  That idea now looks less likely, and consumers who are retirement focused are also more likely to pull in the reins in order to set more capital aside.

Barron’s outlined several large retail names which could underperform in the coming months, but ZachStocks has been offering ideas in some smaller companies which could experience an even sharper drop due to their volatility.  It may make sense to add short positions in some of the following names.

• Blue Nile, Inc. (NILE) – The stock is currently trading at about 64 times expected earnings for this year.  Even if the company is able to grow by the expected 25% next year the stock looks extremely over-valued.  Revenue continues to decline and while the decline could be worse, there is little to justify the optimistic price investors are placing on the stock.
• Chipotle Mexican Grill (CMG) – Restaurant chains will likely see traffic slow this fall as unemployment continues to be high and consumers work their way towards reducing credit balances.  The stock appears to have had a false breakout in July and is now trading back below the key $90 area.  Look for weakness and a possible trade down to the $60’s for starters.
• CarMax, Inc. (KMX) – While the stock has been stronger than I expected a few months ago, the dynamics surrounding autos has been artificially propped up and will likely lead to investor disappointment in coming months.  With a published PE of 45 and struggling sales and earnings, KMX could quickly become a losing proposition.

There are plenty of other short ideas that we will be profiling in future notes.  Not only is the retail sector at risk, there are plenty of other investments in technology, finance, healthcare, and some international plays which could yield strong returns for investors willing to short.  Whether you offset your risk by shorting falling stocks, hedging with options or futures, or simply raising cash; the current dynamics indicate that taking some profits off the table and having a defensive plan in place will be well worth the effort.

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