The Scoop on the Retail Sector

— “Calling the Trend” Column, by George Leong, B. Comm

Predictions vary on the outlook for the retail sector. Some feel that the bottom is here or near, while others including myself believe that there will be continued struggles ahead of us in the fourth quarter. It’s true that there have been some positive signs, but I feel the hurt will continue for at least the next several quarters or more. Retailers, even some of the discounters, continue to fight to win customers. Prices are being slashed to eliminate excess inventory and this is impacting operating margins, which have been on the decline. Bellwether Wal-Mart Stores, Inc. (NYSE/WMT) warned that the global recovery will be slow. It is focusing on its growth in China and India.

Some argue that some retailers have beaten earnings estimates, but keep in mind that the bottom line was improved primarily via cost-cutting efforts. The problem is that there are limits to how much you can cut from costs. At the end of the day, retailers will need to increase their sales in order to drive profits instead of doing the latter by cost-cutting. Until I see this happening, it will continue to be a difficult environment in which to invest in retail stocks.

More evidence of the sluggish sales in the retail sector emerged recently with soft retail data. Investors are hopeful that the worst is over and that the recession is ending soon, just in time for the busy Christmas shopping season, but it may be more hope than reality.

According to the National Retail Federation, the key holiday sales are estimated to fall one percent for the November and December months.

My concern continues to lie with the declining home prices and their negative impact on wealth and consumer spending. We need to see property wealth return before consumers begin to buy furniture and other big-ticket items for their homes.

Moreover, there needs to be an improvement in jobs. The September non-farm payrolls were weak and the consensus is that the unemployment rate will reach 10% by early 2010 before improving. As long as people have to worry about losing their jobs, they will hold off on spending on non-essential goods and services. This is a problem and could hamper the economic recovery.

Also keep in mind that the positive impact from the $800-billion stimulus program is drawing to an end. There are less economic incentives offered and this will surely impact whether a person spends.

In addition, debt levels are continuing to expand, and will become more of a concern going forward, as consumers watch their disposable income fall. A good majority of people have fixed budgets, and higher financing costs will reduce money available for other purchases.

There is concern that retail sales heading into the third and key fourth quarters will continue to be weak, especially given the post-Thanksgiving shopping period heading into Christmas, which for many retailers is the prime shopping period of the year.

Watch for the retailers in the fourth quarter. If you are currently holding retail stocks, here is what you may want to consider. Given the bearish sentiment towards retail stocks, you could write some covered call options to generate some premium, thus reducing the overall average cost of the stock in question.