Where’s the Consumer Buying Stuff at 2006 Levels?

This morning’s retail sales data surprised many with a 2.7% spike, the biggest gain in three years. Excluding auto and gasoline sales, the advance was only 0.6%. That’s important, as you might have guessed, because of the boost car makers got with the government-sponsored “cash for clunkers” and the national average for fuel prices settling in above $2.50 per gallon.

Still, the optimists say, other categories of sales were up as well. For example, electronics and appliances were up 1.1% for August, general merchandise sales climbed up 1.6%, and food and beverage stores edged up 0.5%. Plus, a 0.6% gain is a whole lot better than July’s 0.4 drop. If the hard numbers weren’t enough to convince you the consumer is back, here’s an expert quoted by Bloomberg:

“There’s quite a bit of pent-up demand,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “At the moment, it looks like the consumer is buying goods besides autos. The outlook has brightened immeasurably.”

“Brightened immeasurably?” That’s economist-speak for “I’m not really sure how or why, but things are looking up.” The reality is that we are talking about a jump in sales that looks big—from zero. And year-on-year comparisons illustrate the drop off the precipice last summer as August 2009 data is down 5.3%, improving from down 8.5% for July.

As I’ve said here many times, consumer spending will lag the economic recovery just like unemployment. And this is because we are still recovering from the worst systemic financial crisis in 75 years, which means the consumer will continue to retrench as job losses and the credit crunch hit Main Street ever harder.

This is a generational crisis that impacts the psyches of everyone from your parents to your children because no one saw a near-Depression in their future and now we wonder just how fragile our economy is. When people think of scary potential unknowns like this, they get very conservative with their money.

Should Retails Stocks Be So Bid?

I pose the question today and will provide more analysis going forward, but a simple way to start with this problem is to look at the prices of retail stocks vs. retail sales for the last three years. From January 2006 through January 2008, the sales data averaged about +2% year-over-year.

Corresponding to this period of the still-strong, still credit-addicted consumer, two retail ETFs were also trading higher than they are now. The Retail HOLDRS Trust (RTH) traded $10 to either side of $95 and the S&P Retail SPDR ETF (XRT) traded between $35 and $45.

Today the RTH is trading near $88 and the XRT is up to around $33, both right below their average levels during those last two years during the boom. Both ETFs have been strongly bid as institutional investors have been curiously interested in consumer stocks since the March lows. I say “curiously” because I truly can’t figure it out. This probably makes me the dummy here, so I will give fund managers and professional equity analysts the benefit of the doubt until I gather more evidence they are wrong.

For now, I simply wonder if the consumer can really be back enough already to justify valuations in the mid-teens. From the top-ten holdings of the RTH, including big boxes like Wal-Mart Stores (WMT), Home Depot (HD), Walgreen Co. (WAG), Target (TGT), and Best Buy (BBY), the average P/E is around 15, with Amazon (AMZN) hauling around a monster 50+ multiple. A P/E of 15 might not seem like a drastically expensive multiple, but you have to ask if retail is going to be the leading sector here and if it deserves an above-market valuation.

Another way to look at the problem is to compare the retail sector to the rest of the market on a price-performance basis. For the last year, the RTH has outperformed the S&P 500 Index (SPX) by around 5%, while the XRT has clobbered the broad market by more than 15%. And both have done even better for the last six months.

Versus the Nasdaq (COMP), which is down 7% for the last 12 months, the RTH is running only a couple of points behind, while the XRT is back to square. The XRT also trounces the COMP for the past six months (up 60% vs. up 45%), while the RTH falls behind considerably (up only 28% vs. up 45%), likely due to it’s heavier concentrations of Home Depot and Lowes (LOW). I make the tech-heavy Nasdaq comparison here to highlight retail vs. a star sector performer and leader of the stock rally this year.

Bottom line: Given the price appreciation already, consider the strong possibility of the retail sector underperforming the broad market the rest of the year. Seasonal optimism may already be priced in, and these stocks will be most susceptible to any news or data signaling the true, long-term impact of this economic downturn on consumers.  Buying out-of-the-money December or January puts or selling OTM call spreads, on one or both ETFs, might be a low-risk, high-return way to play this trade opportunity.

"Mind the risk, bank the profits!"