Retail Industry

Through the middle of June, the S&P Retail Index (RLX) is sitting on gains of about 13% year-to-date. The strong relative performance of retailing stocks thus far has been due to low expectations coming into 2009, "less bad" sales declines and cost cutting efforts. This combination allowed retailers to easily beat first quarter earnings estimates.

Going forward, however, retailers are going to have a harder time beating estimates because expectations have climbed higher, while "less bad" results and cost cuts are already reflected in analyst estimates. Moreover, for the retailers to deliver better-than-expected results in the months ahead, the upside will have to come from an improvement in sales growth. This is unlikely because there are simply too many headwinds for the consumer to overcome.

These headwinds include wealth destruction from the housing and equity markets and higher unemployment, which has reduced discretionary income. Additionally, financial institutions are tightening credit standards and reducing or eliminating credit lines. The stricter lending environment is reducing the consumers’ ability to borrow and spend.

In past recessions, consumers relied heavily on credit cards to finance spending. In the current downturn, consumers are not resorting to credit cards as they did in the past. In fact, revolving debt balances are falling, as financial institutions reduce credit limits, increase interest rates or cancel accounts. Without the ability to take on more debt, consumers are spending less in retail stores, saving more of their income and paying down credit card balances.

What’s more, retail sales in the month of May demonstrate that the consumer is still heading to the mall to make discretionary purchases. Consumers are buying products they need like food, health products and gasoline. May retail sales were soft with most of the weakness in consumer discretionary areas such as home furnishings, electronics and appliances, and department stores. The best-performing areas of retail were defensive, including grocery stores, drug and healthcare stores, and auto parts retailers. As a result, we continue to favor defensive retailers over the more discretionary retailers.

OPPORTUNITIES

In the past few months, institutional money has sold defensive names in favor of more discretionary names, as many money managers are anticipating an economic recovery in the second half of the year. We think this investment strategy has left many defensive retail stocks look attractive.

Two stocks in our coverage that we rate as Buys are Kroger (KR - Analyst Report) and Safeway (SWY - Analyst Report). Kroger's sales should remain relatively intact. Consumers will still need to shop for groceries even with in a weak economic environment. And we think both stocks are undervalued at current levels.

Another stock that we like is GameStop (GME - Analyst Report), which isn’t a traditional defensive name, but its results have remained strong throughout this downturn. Expectations are low for the second half of the year, and we expect the company to top those expectations.

WEAKNESSES

Retailing stocks have experienced huge run up this year, and many are at risk of giving back those gains if a second half recovery does not materialize. The stocks that we believe are the least attractive are those that are well off their lows, but will continue to experience weak sales trends into 2010. Among our current Sell ratings are JC Penney (JCP - Analyst Report), Overstock.com (OSTK - Snapshot Report) and Zumiez (ZUMZ - Analyst Report).