From November 20, 2008 to January 6, 2009, the S&P Retail Index [RLX] rose 41%. Not a bad move for a group of stocks that had one of the worst holiday shopping seasons in recent memory. It appears that investors became more bullish on retailers because of seemingly cheap valuations, anticipated benefits from a federal government stimulus package, and a better economy in the second half of 2009.

In our view, the 50-day upward move in retail stocks was a bear-market rally. Investors should begin to lighten up on exposure to retail stocks. We expect the group to give back those gains as it becomes apparent that many retail stocks are not cheap, that the stimulus will provide at best a short-term boost, and the economy will not turn until 2010.

Our negative view of the group is based on the awful 2008 holiday season, a reduction of leverage in the financial system and, most importantly, consumer attitudes shifting away from borrowing to make discretionary purchases. These factors all point to continued pressure on consumer spending.

As a result, we believe that consumer and retailer trends that began in 2008 will continue throughout 2009. Consumers will focus their spending on necessary items such as food, clothing, and staples. Discretionary purchases will be made when items are significantly marked down. In turn, retailers will focus on reducing square footage, reducing leverage and reducing inventory. This will lead to further negative earnings estimate revisions for retailers for the next few quarters.

OPPORTUNITIES

We see few opportunities in the near term. That said, investors looking for exposure should focus on retailers with stable revenue and earnings. These include defensive plays including discounters, retailers with debt-free balance sheets, and supermarkets.

Two stocks we like in this environment are Kroger ( KR - Analyst Report ) and PetMed Express ( PETS - Analyst Report ) .

Kroger's sales should remain relatively intact. Consumers will still need to shop for groceries even with in a weak economic environment. Kroger is doing a good job of gaining market share by competing on price and selection.

PetMed Express operates the nationwide pet pharmacy 1800PetMeds.com. The company markets its health products for dogs, cats and horses. PETS' revenue is holding up well in this challenging retail environment. The company continues to manage its operating costs, which has enabled the company to produce strong earnings growth.

Another long-time favorite of ours is GameStop ( GME - Analyst Report ) , which reported blow-out numbers for the holiday season with same-store sales up 10%. The company also increased its EPS guidance for the fourth quarter.

WEAKNESSES

We would avoid most names in retail. The stocks that are least attractive in this environment are those companies with levered balance sheets, marginal businesses, or those retailers that rely on the credit markets to buy inventory or sell its merchandise. We have Sell ratings on department stores including JC Penney ( JCP - Analyst Report ) and Nordstrom ( JWN - Analyst Report ) , specialty retailers Cost Plus ( ) and Tractor Supply ( TSCO - Analyst Report ) , and e-commerce firms Overstock.com ( OSTK - Snapshot Report ) and Priceline.com ( PCLN - Analyst Report ) .