Lackluster Holiday Puts Retail Stocks Out of Favor

It's been a long time since I shopped for toys, but from a layman's perspective this year seems to lack the must-have items of seasons past. Ironically, the homepage on Toys 'R' Us over the weekend was advertising specials on Transformers, Elmo and Nerf — all toys that were popularized in previous generations. It's hard to see what's driving Mom and Dad to plunk down that extra hundred bucks this holiday season.

Not surprisingly, estimates for holiday sales are uniformly cautious. According to the National Retail Federation, 2007 holiday sales are expected to rise 4% year over year, the slowest pace since 2002. There aren't many analysts who are bullish on the American consumer, the domestic economy or the holidays.

This outlook is more than clear to those who've followed retail stocks in recent months, most of which seem to indicate Santa might as well take this year off. With few exceptions, retailing stocks look frighteningly weak, with many hitting multimonth lows of late. Dillard's (DDS), Sears Holdings (SHLD), Circuit City (CC), 99 Cents Only Stores (NDN), Kohl's (KSS) and Zale (ZLC) are a few off the long list of recent losers.

Retail Wreck

It's another example of how stocks have a knack of predicting the future rather than simply reflecting it. Investors saw that reality on Thursday when Starbucks (SBUX) issued a disappointing financial report, sending shares sharply lower.

To those who had been following Starbucks' price action and that of the restaurant sector in general, this was no surprise. The stock actually provided ample time for longs to exit before the bad news materialized, declining 12% from late 2006 to early 2007, another 14% into the spring, and another 20% into the summer, before the headlines actually broke this fall.

Bad Moves Before Bad News

Regardless of how this Christmas turns out, I believe longs would be wise to consider cutting some of their exposure to retailing stocks. Although we might see some dead-cat bounces in the coming months, the general sector looks to me to be dead money through the first quarter of 2008.

It's worth noting that there are a few standouts. Among the large-box stores, Costco Wholesale (COST) has outperformed, as has Saks (SKS) within the otherwise dreadful department stores. Gap (GPS), for the first time in years, actually is showing the most strength of the apparel names, besting previously hot properties like Chico's FAS (CHS) and Abercrombie & Fitch (ANF).

If I owned any of those outperformers as a win, I'd certainly try and hold on to them. As I pointed out a few weeks back, an all-or-none approach of selling an entire portfolio at the first sign of trouble is a bad idea. A better tactic is to trim the weakest positions while preserving those holding a bid. On a few rare occasions, we are lucky enough to keep the one standout of the group and go on to substantial gains.

If buying the retailers isn't right, then you might question if this is the time to short them instead.

The strict technician would suggest retailers should be sold short, given that there's no objective indication the trend has bottomed just yet. What worries me about the short side is widespread growing consensus that holiday retail sales are likely to disappoint. Right now, it's hard to make the argument the news isn't out already.

If everyone was cheering a particular new toy or gift item even as retail stocks sank, I'd be more likely to short the names. But weak price action and public pessimism leads me to be flat, rather than long or short.

There are bull, bear and trendless markets. And while you want to be long in a bull market, a trendless environment can be as dangerous as a bear one. In a trendless market, you tie up precious capital in ideas that thrash around for years on end — up 10%, down 10%, with no real lasting opportunity to profit long or short.

Motorola (MOT), for example, has covered much of the same midteens territory for the better part of six years, as the stock has digested its late 1990s bull run. Because investments tend not to fall 40% because they're poised to immediately recoup the loss, sectorwide weakness, such as banks, housing and now retail, should be avoided until a new market cycle has begun. More often than not, that's a few years at best.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.