Retail Industry

In February, we've seen several retailers deliver better-than-expected results for the fourth quarter. That resulted in some eye-popping one-day gains of 10%, 20% and even 30%.

In most cases, the upside was due to extremely low investor expectations associated with the 2008 holiday season and not an improvement in their underlying business. Despite the positive reaction to retail earnings reports, we remain negative on the retail industry. Our negative view of the group is based on the weak economic environment, higher savings rates and de-leveraging in the financial system. These factors all point to continued pressure on consumer spending.

The weak economy has caused many to lose their jobs, while many others live in fear of losing theirs. This elevated level of fear is causing many consumers to cut back on purchases and look for ways to save on the purchases they do make. Consumers have also experienced a great deal of wealth destruction from falling home prices and stock market declines.

Most realize that they need to replace those losses by increasing their savings. As consumers increase savings, their overall spending declines. Another facet of the trend to increase savings is a reduction in leverage. This includes paying down current debt and refusing to take on new debt.

Consumers' willingness to buy on credit was key driver for consumer spending in the last decade. A reluctance to borrow for discretionary purchases acts as another headwind for retail sales. What's more, when consumers do go shopping, they will focus on necessary items such as food, clothing and staples. Discretionary items are purchased only when they are significantly marked down.

Most will continue to trade down to cheaper alternatives. In turn, retailers will focus on reducing square footage, reducing leverage, and reducing inventory, all of which is points to a recognition of an industry that is contracting.

OPPORTUNITIES

In the near term retailers could attract a bid, as investors buy into the belief that the worst is priced in. Those investors looking for something longer than a trade should stay defensive and focus on retailers with stable revenue and earnings. These include discounters, retailers with rock solid 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.

We also like GameStop ( GME - Analyst Report ) . GameStop's results have remained strong throughout this downturn, and its stock has been unfairly punished along with the rest of retailers. The company even pre-announced strong holiday results on Feb 19.

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 do not generate enough cash flow to internally finance operations. Among our current Sell ratings are specialty retailer Cost Plus ( ) and e-commerce firm Overstock.com ( OSTK - Snapshot Report ) .