Long or short on retailers?

In mid-November, I had marked a few retailers as potential short opportunities, but was reluctant to pull the trigger on actually investing any money. In retrospect, I’m glad that I waited.

In data released on Friday, the Commerce Department reported that the retailing sector posted its fifth straight month of declining sales with a 1.8% decline for November, but there was positive news in the data. Excluding cars, gas, and building materials, the sector posted a 0.5% gain for the month, according to the Wall Street Journal, defying grim economic news elsewhere. Overall, the rate of decrease in the retailing sector is slowing. August and September declines were in the neighborhood of 6%.

All of this has thrown a wrench into my plans to short retailers, although I still think the sector is in for a very rough patch through the first quarter of next year at the least. Writing over at Portfolio.com, Liz Gunnison tries to parse the reams of retail data from various sources and ultimately advises “to take any retail sales data not published by the Commerce Department with a grain of salt…it’s safer to pay attention to month-to-month or year-to-year trends than to absolute numbers.”

Doing so reveals a worse picture than the economic spin masters would have us believe. Once the data is reported and analyzed, I am confident that we will discover last month’s (November) sales figures were very bad, as compared to prior Novembers. That we can feel heartened by the new data suggests just how bad expectations were. This is borne out by the latest consumer confidence index from the University of Michigan, which nudged up from record lows in November; however, when asked about the future, consumer confidence posted a slight decrease, so there is still plenty of fear in the marketplace, and the likelihood is that consumer spending will continue to fall.

That’s why it’s important to stay focused on the big picture for retailers and not get too caught up in the month-to-month data. The bottom line is that retail sales are now in a long-term period of contraction, and only the strongest, best-run companies will thrive in this atmosphere. Discount retailers will also have a leg up, as evidenced by Walmart’s stock performance – it is one of the few large companies to post a year-to-date increase (nearly 15%) in its stock price.

The retailers that I identified in November as short opportunities – Lowe’s Companies, Inc., Gamestop Corp., Best Buy Co., Inc., Macy’s, Inc., and Sears Holdings Corp. – have performed fairly well as a group since that time (see chart below). Look for that short-term performance to reverse itself over the course of the next month, particularly as the Christmas shopping season data proves less encouraging than many might have thought.

Some might argue that these companies have already been drained of value to the point that they’re bargains. After all, with the exception of Lowe’s (which is trading about even YTD), the companies listed above have shed anywhere from 50% to 70% of their market cap this year. It is true – the real time to be short was the beginning of September, but then again, that was the case for just about every stock. Going short on the retailing sector today is premised on the belief that the economic downturn will be protracted, even though actual economic contraction will not be as severe going forward as it was in the third and fourth quarter of this year. But slowing rates of decline doesn’t add up to a “recovery,” which is probably still 12 to 18 months away. I’ll be watching vulnerable retailers for opportunities to short, and the public’s misunderstanding of recent retail data is likely to produce one of those opportunities before the year is out.