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The health of the retail industry is an important economic indicator, as it is linked directly to consumers and their propensity to spend. Consumer spending holds the key to the well-being of the U.S. market; it accounts for more than two-thirds of economic activity.

The link between consumer spending and the retail industry becomes more relevant as retail sales attract approximately 30% of total consumer spending in the United States. Also, the retail industry ranks among the top U.S. industries and employs an enormous workforce, thereby deciding the health of the job market.

Before jumping on to the trends in retail, here’s a peek into the key economic indicators, which suggest where the market is heading.

On the whole, the U.S. economy seems to be in good shape. Per the ‘third’ estimate released by the Bureau of Economic Analysis on Sep 28, 2017, the U.S. economy expanded at an annual rate of 3.1% in the second quarter. This marks an increase from the ‘second’ estimate of 3% and from 1.2% growth in the first quarter of 2017.

A favorable GDP growth rate along with rising disposable income, an improving labor market with unemployment rate to a 16-year low, a lift in economic activity post hurricanes and a low inflation rate have considerably boosted consumer sentiment, which was at a 13-year high in October. Data by the University of Michigan indicated that U.S. consumer sentiment index surged to 101.1 in October from 95.1 in September.

Additionally, U.S. retail sales rebound sharply in September, after a pullback in the month of August, on sturdy auto sales, rising gasoline prices and increased demand for building materials. This clearly indicates that the economy is gathering pace and setting the stage for an upbeat holiday season.

Data compiled by the Commerce Department reveals that U.S. retail and food services sales rose 1.6% in September to $483.9 billion, following a revised reading of 0.1% decline in August. Moreover, retail sales increased 4.4% from September 2016.

Changing Retail Landscape

The Retail sector fully lives up to the saying, “The only thing that is constant is change.” This landscape has evolved from a marketplace where goods are bought and sold to a forum with multiple avenues to engage customers. With the advent of technology, the face of retail has changed from small/big retail outlets to omni-channel stores, where one can check products/prices online and buy in stores, and vice versa. Today, the success mantra in retail hovers around finding new ways to market their products.

To put it simply, the retail sector is on transformation mode – with store-based retailers now ditching their traditional stores and embracing omni-channel concepts, which provide a more seamless shopping experience both online and in-stores. The result is, customers can use computers, smartphones or tablets for shopping or visit a store if they want to.

Parallel to this shifting retail landscape, the industry is facing major challenges from a strong U.S. dollar, volatile commodity costs and global uncertainty. The volatility in U.S. dollar for quite some time now has been hurting retailers with worldwide operations. Also, the competitive situation continues to worsen as industry players vie for the top spot, focusing on speedy deliveries and enhanced customer experience, while battling margin pressure.

Key Retail Metrics

The key data in retail industry analysis is comparable-store sales (comps) as it excludes sales at newly opened and closed stores. We observe that sales data for the month of September was more or less negative as the majority of retailers that report monthly comps faltered. With many retailers having discounted the practice of reporting monthly comps, we only have five of them providing this key metric for September.

The list of gainers in September had Washington-based retailer of sports-related teen apparel Zumiez on top. The company reported 9.3% increase in comps, with sales improving 12.6% to $84.4 million from the year-ago period. This was the company’s seventh straight month of comps growth. Based on the solid quarter-to-date performance, the company raised earnings and sales forecasts for third-quarter fiscal 2017.

Right behind was warehouse retailer Costco Wholesale Corp. (COST - Free Report) , which posted an 8.9% rise in comps, while total sales rose 12.1% to $12.40 billion. Comparable e-commerce sales for the month of September surged 30%.

On the other hand, apparel and accessories retailer Cato Corporation disappointed the most withan 11% decline in comps and an 8% fall in sales to $76.2 million. We note that the company’s comps have been declining for more than a year, primarily due to a tough apparel retail scenario.

This was followed by The Buckle Inc. (BKE - Free Report) , which continued with sluggish comps for the ninth straight time, reporting a 5.7% decline in comps and a 6.1% fall in net sales to $77.9 million for September.

Going down the line, we have specialty retailer of women’s intimate and other apparel, beauty and personal care products, L Brands Inc. (LB - Free Report) . The company posted a comps decline of 2% while sales increased 1% to $981.6 million. This marked the company’s 10th straight month of comps decline. Further, the company expects comps to decline in low-single digits in October.

Retail/Wholesale Sector – A Mixed Bag

The Retail and Wholesale is more of a mixed bag when it comes to its performance trend. The sector has outperformed the broader market year to date. In this time frame, the sector has surged approximately 18.8%, while the S&P 500 index has advanced 14.5%.

Looking at the sector’s trailing 12-month price-to-earnings (P/E) ratio, which is the most reliable multiple to value retail stocks, it looks pretty overvalued when compared with the S&P 500. The sector has a trailing 12-month P/E ratio of 27.9, which is above the median level of 25.9.

However, this space compares unfavorably with the market at large, as the trailing 12-month P/E for the S&P 500 is at 20.8 and the median level is 19.8. The Retail and Wholesale sector’s stretched valuation shows that there is only little upside left for the space when compared with the S&P 500 market index.

The group’s Zacks Sector Rank confirms this view. This 222-company sector has seen 110 positive and 62 negative revisions in earnings estimates in the recent past. It carries a Zacks Sector Rank of #15 (out of 16), placing it at the bottom 6% of the Zacks Rank sectors.

Zacks Industry Rank – Positive

Within the Zacks Industry classification, retailers are broadly grouped under the retail and Wholesale sector (one of the 16 Zacks sectors) and are further sub-divided into 18 industries at the expanded (aka “X”) level -- Retail–Computer Hardware, Retail–Home Furnishings, Retail–Discount Stores, Automotive–Retail and Wholesale–Parts, Retail–Mail Order, Building Products–Retail, Automotive–Retail and Wholesale, Retail–Restaurants, Retail–Consumer Electronics, Retail–Jewelry, Internet – Commerce, Retail–Apparel and Shoes, Food–Natural Foods Products, Retail–Pharmacies and Drug Stores, Retail–Miscellaneous, Retail–Supermarkets, Retail–Convenience Stores, and Retail–Regional Department Stores.

We rank all the 250 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one week rebalance, the top half beat the bottom half by more than twice as much. To learn more visit: About Zacks Industry Rank.

The Zacks Industry Rank is #7 for Retail–Jewelry (top 3%), #24 for Retail–Consumer Electronics (top 9%), #24 for Retail–Convenience Stores (top 9%), #34 for Retail–Discount Stores (top 13%), #63 for Automotive–Retail and Wholesale–Parts (top 25%), #68 for Retail–Apparel and Shoes (top 27%), #88 for Retail–Supermarkets (top 34%), #110 for Retail–Regional Department Stores (top 43%), #110 for Retail–Pharmacies and Drug Stores (top 43%), #110 for Retail–Mail Order (top 43%), #177 for Food–Natural Foods Products (bottom 31%), #188 for Internet – Commerce (bottom 27%), #188 for Building Products–Retail (bottom 27%), #222 for Retail–Restaurants (bottom 13%), #222 for Retail–Home Furnishings (bottom 13%),  #239 for Retail–Miscellaneous (bottom 7%), #240 for Automotive–Retail and Wholesale (bottom 6%), and #253 for Retail–Computer Hardware (bottom 1%).

On analyzing the Zacks Industry Rank for the constituent industries in this space, it is apparent that the overall outlook for the Retail and Wholesale sector is Positive.

Sector Level Earnings Trends

The Q3 earnings season (meaning September-end quarter results) is at its peak. The reporting cycle has been positive and reassuring so far. Further, we expect this view to strengthen in the coming days. Three positives evident from the reporting cycle are that there is momentum in revenues, the above-average positive surprises continued in the third quarter, and the revisions trend for the December quarter is favorable.

As of Oct 20, we have seen results from 87 S&P 500 members, accounting for 24.7% of the index’s total membership. Of these, approximately 71.3% have delivered positive earnings surprises, while 70.1% beat top-line expectations. Total earnings for these index members were up 9.4% from the year-ago quarter, while revenues increased 7.3%.

For Q3 as a whole, total earnings are expected to be up 2.6% on a 5% increase in revenues. This will follow 11.2% earnings growth and 5.5% revenue upside registered in second-quarter 2017.

Combining results on board and upcoming, earnings for the Retail sector are expected to decline 2.2% in Q2, with revenues anticipated to grow nearly 5.8%.

For more details on earnings of this sector and others, please read our ‘Earnings Preview’ report.

Retail Stocks Worth Buying Now

The Retail sector may seem to be mature at the moment with little upside left. However, there are gainers in this space too that might be solid investment bets. Here are a few stocks that have been witnessing positive estimate revisions and sport a Zacks Rank #1 (Strong Buy) or #2 (Buy):

Zumiez Inc. (ZUMZ - Free Report) : The stock gained a whopping 43.8% in three months. Earnings estimates for the current fiscal year were revised 11.8% upward over the last 60 days. Also, the stock surpassed estimates by an average 27.1% in the trailing four quarters and has a long-term EPS growth rate of 18%. The stock currently has a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.

DSW Inc. (DSW - Free Report) : The stock saw nearly 1 cent upward revision in earnings estimates for the current fiscal year in the last 30 days. Also, the company delivered an average positive earnings surprise of 14.3% in the trailing four quarters. This Zacks Rank #2 stock has gained 17.4% in the last three months and has a long-term EPS growth rate of 6.3%.

Restoration Hardware Holdings Inc. (RH - Free Report) : The stock gained nearly 20.1% in the last three months. It has seen earnings estimates for the current fiscal year being revised 1 cent upward in the last 30 days and delivered an average positive surprise of 21.7% in the trailing four quarters. The company has a long-term EPS growth rate of 30% and sports a Zacks Rank #1.

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