Why You Should Stay Cautious with the Retail Sector

by George Leong, B. Comm.

The retail sector is an area about which I remain cautious. There have been some positive signs, but I feel that the struggles 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.

Some retailers have managed to beat 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 cost-wise. At the end of the day, retailers will need to increase their sales in order to drive profits, and not via 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 the recession is ending soon — just in time for the busy Christmas shopping season — but it may be more hope than reality.

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With the massive $800-billion stimulus program filtering down through the economy, there have been positive signs, but there remain problem areas that will impact spending. And with consumer spending accounting for two-thirds of GDP, the fear is real.

The housing market is improving, but home prices continue to be well off from their highs. We need to see property wealth return before consumers begin to buy furniture and other big-ticket items for their homes. We also need to see jobs losses decline. As long as people worry about losing their jobs, they will hold off on spending on non-essential goods and services. This is a problem that could hamper the economy further.

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

Watch 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.

If you are negative on the retail sector and want to short, I would suggest you reconsider, unless you have a stomach for risk. If you need to short, please place appropriate stop-buys on the short position or you could find yourself vulnerable should the stock stage a strong rally. A better alternative to shorting would be to buy Put options or initiate Bearish Put Spreads.