If the consumer is the key to the recovery then the most recent retail sales data and retailer earnings reports are disquieting, indeed.

Retail sales fell 0.1% last month, the Commerce Department said, when economists expected them to rise. Meanwhile, the Labor Department said new jobless claims rose when economists expected them to fall. And, perhaps even more important, sales at Wal-Mart (WMT), the world's biggest retailer, fell during its fiscal second quarter yet another metric that fell short of expectations.

If better sales and an improved jobs picture are the keys to increased consumer spending -- especially heading into the teeth of the critical back-to-school shopping season -- then the latest news hardly bolsters the case for retail stocks, especially at these levels. If anything, the data undermines the remarkable run in retail shares since the market bottomed back in early March. The S&P Retail index is up a massive 60% since that time, beating the broader market by a full 10 percentage points over the same period.

Now that run-up is even harder to justify. July's retail sales were a "real clunker," says Richard Moody, chief economist and director of research at Forward Capital, an Oakton, Va.-based real estate investment company. Furthermore, core retail sales, which exclude autos, have now dropped for five straight months, he says, and given the weak labor market, consumer spending looks to be tepid at best over the coming quarters.

Translation: It looks like the red-hot retail rally is poised for a pullback. True, the run-up isn't being driven by the same voracious appetite for risk that we've seen in other speculative investments, such as small-cap stocks, junk bonds or emerging markets. Rather, it's a rational bet that all the cost cutting and inventory paring retailers are doing today will spring load margins and boost earnings when sales start to grow again, says Brett D'Arcy, director of investments research at CBIZ Financial Solutions (CBZ), a Cleveland financial services firm.

"All the retailers reporting better-than-expected earnings is a result of cost cutting, but they aren't necessarily low-quality earnings. They have to get their costs in line. If consumers get a little optimism, they'll go back to spending and that could unleash pent-up demand," says D'Arcy.

Brian Sozzi, an analyst with Wall Street Securities, is less optimistic. He says current stock valuations for the sector are in many cases a result of wishful thinking. Too many retail stocks have gone too far, too fast, trading at valuations that just aren't supported by the fundamentals, he says. Specialty retailers Abercrombie & Fitch (ANF) and American Eagle Outfitters (AEO), for example, are trading at 21 times next year's earnings, despite not showing any sign of a sales turnaround. Both those names are more than twice as expensive as their own five-year averages, according to Thomson Reuters, as well as pricier than the consumer discretionary sector, which carries a forward P/E of nearly 18, according to Yardeni Research. The S&P itself goes for 17 times forward earnings. (See chart below for July same-sales and P/Es of some major retailers.)

"You're seeing these stocks trade on the expectation that the fourth quarter [the all-important holiday selling season] will be the big turnaround," Sozzi says. "I would expect some pullback in retail because I think back-to-school is going to be disappointing, and that doesn't bode well for the holidays."

Sozzi projects that consumers will remain skittish well into 2010. He sees the personal savings rate steadily climbing to 10% next year, more than double what it is now.

"We've seen the retailers do a pretty darn good job of reining in costs and running much tighter and leaner ships," says Matthew Kaufler, co-manager at Federated Clover's All Cap Value investment portfolio. "That's all fine and good. But here's the rub: At some point they are all going to want to grow again, and if retail sales remain weak, they will have to cut prices to gain market share. That will hurt margins."

If retailers get into markdown wars with each other in order to boost market share, well, so much for any sales boost finding its way down to their bottom lines. Retailers, says Kaufler, are "scared to death" about unemployment and personal savings picture heading into the holidays. He expects a broad-based pullback in the consumer discretionary sector over the next 60 days.

So while retail stocks could have some more upside left in them, most appear priced for more spending and less savings --- something the latest readings on the economy don't support.