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Industry Uncertain About Retail Stock Rebound

Economic challenges persist, challenging 'early cycle' theories.

After the outright free-fall of last fall and winter, retail stocks found their footing in the second quarter and rose 9.8 percent during the months of April, May and June.

“Catastrophe has been averted,” said Paul Nolte, director of investments at Hinsdale Associates, noting government spending has helped stabilize the economy.

“The next step is to actually start to see real improvement in the economy,” Nolte said. “If we don’t get real improvement…we kind of wallow around here for a while.”

But changing consumer mores could upset the historical ebb and flow of retail shares, which in the past have been “early cycle stocks,” rising midway through a recession in anticipation of increased spending as the economy improves.

Analysts are split on whether the pattern will hold true for this recession, the worst in more than 70 years.

“You’re going to see more saving than spending,” Nolte predicted. “That obviously will hurt retail. My gut would tell me that they’re [retail stocks] probably not going to be early cycle anymore. I don’t know what will be the early cycle or for that matter where retail will fit in. My guess is that retail will be a midcycle [sector], it will much more closely follow economic trends.”

The S&P Retail Index ended the quarter with a 0.7 percent dip Tuesday to close at 322.55. Retail stocks hit their low for the year on March 6 and have risen 44.5 percent since then.

Taking a broader look, the Dow Jones Industrial Average fell 1 percent Tuesday, but advanced 11 percent for the quarter to end at 8,447. So far this year, retail stocks are up 15.5 percent, a far better performance than the Dow, which has retreated 3.8 percent.

Stocks are often looked at by calendar quarters, even though most retailers are about a month behind, following a fiscal year that begins in early February.

There are still a host of challenges for the economy, consumers, retailers and their suppliers in the second half.

Consumer confidence fell last month and unemployment stands at 9.4 percent and is projected to keep rising. Consumers are also saving more, stashing away 6.9 percent of their disposable income in May, an increase from a savings rate of 1.8 percent for all of last year.

A rise in savings is good news for household finances, but trouble for retailers who have spent the last several years positioning themselves for never-ending growth. And hanging over everything in the fashion world is the question of the lasting impact of the financial crisis on the consumer, who is still contending with the fallout in the housing sector and tight credit markets.

Luxury, once thought to be nearly recession-proof, could prove to be a canary in the coal mine.

High-end department stores have been among the hardest hit in the recession and some designers, such as Stefano Gabbana and Domenico Dolce, are working to lower their prices in the face of a changing consumer. The duo cut prices 10 to 20 percent for spring shipments of both Dolce & Gabbana and D&G.

“The idea is to peel off the superfluous because there are too many clothes, too many seasons, too much advertising — too much of everything that is tacked onto the final price,” Dolce said. “We want to go back to how things were 20 years ago. It’s about drawing the line.”

Whatever happens over the rest of this year, there were plenty of opportunities for investors to make boatloads of money in the fashion sector in the second quarter.

One of strongest gainers was Jones Apparel Group Inc., which shot up 155.5 percent in the quarter, when it posted a smaller-than-expected first-quarter loss and said it would close 225 unprofitable stores by the middle of next year. Saks Inc., among the hardest hit stocks in the early stages of the credit crunch, and J. Crew Group also saw its shares more than double and many others bounced back strongly.

“These stocks doubled and tripled because they were way oversold,” said Todd Slater, analyst at Lazard Capital Markets. “Investors were nervous about consumer names generally.”

Even though the retail stocks are more realistically priced than they were, Slater said the sector could still hit its stride in the early part of the economic cycle and move higher this year.

“We anticipate a meaningful margin recovery in retail and consumer names starting in the fourth quarter, and I believe investors should be placing their bets now, while the environment is a little bit soft,” he said.

Even if stocks do bounce back further, the dynamic in the sector is undeniably changing as chains curtail their expansion plans and focus on leaner organizations.

“Right now, it’s not about growth, it’s about survival,” Slater said, projecting there would be a net loss of about 500 apparel stores this year. “The retail world needs to contract probably even at a greater rate.”

Some of the industry’s strongest players actually turned in the worst stock performances this spring.

Among those losing ground in the quarter were Wal-Mart Stores Inc. and one of its suppliers, VF Corp. Both companies are seen as well managed with a broad enough base to weather the economic storm and neither felt the brunt of the biggest stock declines in the half-year leading up to the second quarter.