A Moody’s report on Wednesday raised new concerns for the vulnerable economic recovery.  Credit card defaults for August rose to a new record at 11.49% underscoring the difficulty consumers are facing in today’s market.  Credit card defaults are typically highly correlated with unemployment which remains stubbornly high despite the recent strength in equity markets.  The credit card news is likely to weigh on retail stocks as investors had been counting on consumers to increase spending as we approach the holiday season.

The report showed current weakness (as seen in the August defaults) but also points to future concerns which could lead to even higher defaults in the coming months.  The number of loans delinquent at least 30 days also rose in August coming in at 5.80%.  The “early stage” delinquencies (delinquent for 30 to 59 days) was especially hard hit which indicates that individuals are facing new issues when trying to keep up with credit card bills.  The newly delinquent accounts have a good chance of working through the system and turning into realized defaults in the next 2 to 3 months.

As the unemployment rate continues to rise (estimates are for a peak near 10.5%), we should continue to see rises in credit card defaults.  Moody’s currently estimates this peak to be mid-year 2010 with a high of 12% to 13% default rate.  These defaults would be particularly challenging for the three largest US credit card lenders JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC).  But although lenders will have to write off these bad loans, I fear investors in retail stocks will actually bear the brunt of the weakness.

Recently we discussed how shares of Under Armour Inc. (UA) may face disappointment as spending for football season will likely be constrained.  Additionally, our article on Tiffany & Co. (TIF) offered three reasons to avoid the luxury retailer.  Consumers are running out of options for funding spending habits and even those who remain employed and financially secure may find themselves unwilling or unable to spend at the same rates seen previously.

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When dealing with consumer spending, retailers are facing both fiscal and emotional challenges.  In response to the rising default rates, credit card lenders are cutting back available balances in order to shore up their risks.  Employed consumers no longer have a widespread ability to borrow against home equity as home prices have declined, and banks are less willing to offer additional lines of credit.  These are the fiscal issues which are having a very real effect on spending.

Emotional decisions also come into play as workers who remain employed are reluctant to spend on items viewed as unnecessary.  The savings rate has begun to climb as consumers realize the need for financial stability, and consumers who are not defaulting on their loans are usually using excess capital to pay down these balances in case their financial situation changes.  The net result is that retailers are finding it more and more difficult to move merchandise out the door.

It will be interesting to see how the retail industry survives the holiday period.  Last year consumers were certainly in shock after the collapse of many large financial institutions.  But the prevailing sentiment seemed to be that consumers would continue to spend for the holidays in order to “count our blessings” or try to retain some sense of normalcy.  This year consumers are much more entrenched in savings initiatives and I believe more likely to cut back on gifts.  Spending will still pick up relative to the summer months, but I doubt it will be at a level which justifies the massive increase in share price for many of these stocks.

Smart investors should continue to remain vigilant and look for less traditional investment opportunities.  Commodities, precious metals, alternative energy, and a few other niche areas offer investors true value with good growth opportunities.  But traditional buy and hold investors should consider hedging positions in order to protect against losses coming into the end of the year.

FD: Author does not have a position in any of the mentioned stocks.

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