By  on January 5, 2009

Put away the party hats.

New Year’s celebrations have faded, but the financial hangover that drove retail stocks down 31.9 percent in 2008 is expected to linger on.

Retailers won’t be able to truly start anew until they’ve worked through the excesses of the years-long credit binge that pushed consumer spending and retail expansion to the limits.

Still, it will be possible to make money trading retail shares this year; it just won’t be easy.

“It’s going to be a real stock picker’s market in the retail, apparel and footwear industries,” said Laurence C. Leeds Jr., chairman of investment firm Buckingham Capital Management. “There will be winners and losers. Several of these stocks are down so far that they’re starting to get to the point where they represent compelling value.”

Last year set the bar extremely low for retail stocks. The Standard & Poor’s Retail Index fell as gasoline prices soared earlier in the year, but retail issues fought their way back into positive territory by mid-September only to drop again as the financial crisis swept through Wall Street. The index ultimately came to rest at 279.26, down 130.68 points from the end of 2007.

With consumers focused on low prices more than ever, Wal-Mart Stores Inc. came into its own. In a rare exception to the broader trend, the discount giant’s stock rose 20 percent to $56.06 in 2008.

Overall, retail shares fared just a bit better than the market. The Dow Jones Industrial Average fell 33.8 percent to 8,776.39 last year, as job losses piled up, credit markets stopped functioning and consumer confidence fell to all-time lows. (For a look at where stocks stood after their first day of trading in the new year, see page 16).

The shine even came off luxe retailers, which were once thought to be near recession proof. Last year, shares of Saks Inc. fell 78.9 percent to $4.38, as shares of Nordstrom Inc. dropped 62.6 percent to $13.31.

“I look for the high net worth consumer to be quite stingy in his purchases,” Leeds predicted. “I look for the deleveraging of the consumer. I think it’s going to be a very difficult year for the American retailer. The recession is going to last longer and be deeper than most people think.”

Already the recession that began in December 2007 and steadily pressed down on businesses and consumers has exacted a heavy toll.

As the sea of holiday sales signs announcing up to 70 percent off attested, many stores were unprepared for the downturn and unable to react quickly enough. Just as the credit crunch hit its stride and consumers froze spending, retailers were stuck with goods they couldn’t sell and a sudden desire to build up cash reserves like never before.

Stocks spiraled and companies that had been deemed strong and steady were suddenly viewed as suspect by investors.

And many expenditures — from new stores to holiday parties — were put off as the financial drama took center stage.

“It was a very tough year for retailers and particularly for managements that had big plans that didn’t necessarily materialize because the consumer was scared, worried and unable to buy anything but essentials and a few gifts,” said Walter Loeb, retail consultant.

Thankfully, Loeb said 2009 will not be a replay of 2008 and he expects retail stocks to start looking better by the second half. That relief, though, should it actually come, is still months in the future.

“I don’t think the worst is over,” said Loeb, who ranked 2008 as the worst year for retail in his 59-year career. “The first half of the year will be terrible. It’s just that I think the second half will be, in comparison with the year before, less threatening.”

Because retail stocks tend to react positively to conditions early in economic cycles, they are usually among the first to recover after a downturn.

Although they got caught with too much inventory and inefficient cost structures when the economy weakened, retailers should be relatively lean and mean by the time consumers are ready to spend again and lead other stocks out of the doldrums.

In the meantime, strong companies with the means and determination to do so will begin to inch in on their competitors.

“There are certainly some players who are well positioned from a cash perspective to drive for market share,” said Matt Katz, managing director at Alix Partners LLC, a restructuring and advisory firm.

So far, deal making has more or less ground to a halt on the U.S. retail scene, with would-be acquirers waiting until the financial world settles some. But companies such as Kohl’s Corp. and Forever 21 Inc. have moved to expand their footprints, snatching up locations from the now-defunct Mervyns chain, which began liquidating in October.

Kohl’s stock fell 21 percent last year to $36.20.

Retailers are expected to continue to struggle, with weaker players at high risk and stronger firms cutting back on expenses and pressuring suppliers to help them eke out what profit they can.

Vendors are suffering as well and clamping down on their suppliers.

“That will ripple through the manufacturing supply base and the raw material suppliers,” Katz said. “What that will do is either slow new product introductions or create more opportunities for exclusive product introductions.”

It will be a while before business is back to normal.

“Until consumers feel that their paycheck is safe, we will be in a retrenchment mode,” Katz said. “We’re all nervous that we’re going to get a tap on our shoulder at work and we’re going to be sent home.”

How much this consumer malaise and the shifting financial landscape forces the fashion industry to evolve is an open question, but significant changes could be in the offing.

“I don’t think the vast majority of retail mass goes away, but certainly companies will look to mitigate risk,” Katz said. “Where is your risk? Your risk is in time; making significant bets on product months before it hits the shelf. Folks are going to look for ways to speed the product development process.”

That could mean anything from tweaking sourcing practices to adjusting the sometimes-uneasy partnership between stores and vendors.

“There are going to be some changes in how we operate, but it’s not going to be that a model gets developed overnight,” Katz said.

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