From Wall Street’s perspective, the retail sector is not the place to be in 2008, as analysts predict a recession or at the least a deeply softened economy.

“We believe the U.S. will fall into a recession or get pretty darn close in the first half of 2008,” said Jeff Black, senior vice president at Lehman Brothers. “The current earnings slowdown mirrors the lead-up to the [2001] recession, with growth declining against easy comparisons.”

Analysts are expecting most companies to lower earnings estimates during February and March quarterly conference calls.

In the fourth quarter of 2007, concerns over a weak housing market, higher gas prices and softer consumer spending caused many retailers to issue a cautious outlook for fiscal 2007 as well as the first half of 2008, noted Kate McShane, retail analyst at Citi Investment Research, in a research report.

As a result, current, deflated stock prices reflect weak sales numbers and the anticipation of December same-store sales and fourth-quarter earnings results. Retailers and vendors have set new 52-week lows over the past two months.

“It’s like [stocks] are being taken out back and shot,” said Steven Sheldon, director of SMS Capital Management. “It’s unbelievable how cheap stocks are getting right down to the places that are usually resilient, such as pharmacies.”

Disappointing job growth and a rising unemployment rate sent the Dow Jones Industrial Average down 1.96 percent to 12,800.18 and the S&P Retail Index fell 3.89 percent to 378.86.

Even teen retailers, which were believed to be immune to higher energy and food costs, a weak labor market and the subprime mortgage crisis, are seen as facing top-line growth challenges. Black expects Abercrombie & Fitch Co. and American Eagle Outfitters Inc. to experience operating margin erosion in 2008.

And while luxury retailers should fare better than most, sales in the sector will also be more moderate than in the past, said Roz Wells, chief economist at the National Retail Federation.

And apparel vendors will also face many of the same retail challenges in 2008, but on a much larger scale, McShane predicted.

“We are keeping an especially close eye on vendor-retailer relationships, many of which appear to be progressively strained as both sides seek to gain an edge on margins under top-line pressure,” she wrote, adding that retailers have the upper hand.

This story first appeared in the January 7, 2008 issue of WWD.  Subscribe Today.

In order to mitigate these risks, manufacturers have been diversifying into other brands, entering untapped retail channels and opening their own stores with varying degrees of success.

But despite this economic turmoil, Black said softline stocks can outperform over the year as the second half of 2008 becomes more stable.

“Overall, there is a weaker spending environment, but this doesn’t mean we don’t have retailers who are doing well,” Black said. His top picks include Urban Outfitters Inc., Gap Inc. and AnnTaylor Stores Corp.

“Urban Outfitters remains one of our top picks for 2008. It’s on a short list of retailers posting positive comp sales and growing operating margin. We think Anthropologie can carry its momentum into 2008, while the Urban division continues to recover,” he wrote in a research note.

Meanwhile, Gap and Ann Taylor are seen as turnarounds. Gap has gained some control over inventory management, which should allow for improved merchandise margins, while Ann Taylor’s 2008 earnings estimates are believed to be achievable, with margin comparisons easy during the first half of the year.

On the vendor side, McShane is betting on Dick’s Sporting Goods Inc., Nike Inc., Polo Ralph Lauren Corp. and VF Corp. to outpace peers. “We would put money on VF Corp. based on its limited exposure to department stores, and Ralph Lauren based on its brand strength, international exposure and luxury business,” she wrote. “Nike is one of the most defensive names in our space and in a stronger position today due to a larger international component and robust balance sheet. Nike is taking dollar share and floor space in a weak U.S. footwear market.”

Black said Chico’s FAS Inc. and Coldwater Creek Inc. will remain challenged, as these retailers attempt to gain control over inventories. McShane said a lot is riding on spring assortments.

“Spring sell-throughs will provide a key indicator for the remainder of 2008, in our view, setting the tone and momentum for fall and holiday,” McShane wrote. “If retailers are able to bring new silhouettes and color palettes, combined with the right merchandising and floor presentation to entice shoppers, we would expect a strong transition through fall 2008. However, if spring 2008 is weaker, we anticipate a difficult retail environment to continue until holiday.”

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