Tis the Season for Retail Stocks But Attention to Detail Is Key

The traditional year-end Santa Claus rally in stocks seems to have started. History shows that retailers tend to make the most money during this time of the year. Often their stocks reflect those expectations from investors.

However, as recent retail sales data suggests the sector is facing some challenges as tapped out consumers are making difficult spending choices, resulting in sluggish sales across the sector. Indeed, investors are faced with a fragmented group of struggling companies which means that attention to detail is the key to success when considering where to invest.

A Trip Down Recent Memory Lane

Those who follow my posts are not surprised to see the unfolding rally in stocks and bonds. For the past several weeks I’ve noted that under the right circumstances both asset classes were ripe for big rallies. It seems that those circumstances have begun to unfold as the most recent consumer price (CPI), producer price (PPI) and retail sales prints delivered very subdued numbers which the market interpreted as a bullish sign that the Fed may be done raising interest rates.

In a recent column, which you can fully access here, I wrote: “as I write there is an encouraging trading pattern developing in the U.S. Treasury Bond market which is spreading to the interest rate sensitive housing and real estate investment trust (REIT) sector.

Moreover, barring a major reversal due to the Fed’s most recent interest rate moves, this trading pattern may be forecasting an end to the higher interest rate cycle.” In addition, way back in October 2023 (that’s a long time ago in market time), I suggested that the same type of conditions which spawned big gains in stocks in early 2023 were repeating.

So far so good as the U.S. Ten Year Note yield (TNX) has reversed its upward thrust and is consolidating near the 4.5% yield area. TNX is also bullishly below its 50-day moving average, as bond traders focus on the steadily slowing trend in inflation. Amongst the biggest beneficiaries of the fall in yields have been the technology and homebuilder stocks, whose gains are well illustrated by price chart for the SPDR S&P Homebuilders ETF (XHB).

Yet, if the market’s rally is to last, other sectors must join homebuilders and technology. And since it’s the holiday season, it makes sense to explore the retail sector as a potential place to put some money to work.

A Revealing Trip to the Mall

To be honest, I wasn’t surprised by the CPI, PPI, or retail sales numbers. In my own weekly shopping travels and back of the napkin grocery tab, I’ve noticed some price relief lately, while also noting the waxing and waning of customer traffic in stores.

Of course, I like to trade what I see, so I took a trip to a still standing and surprisingly busy mall located in a rapidly growing northern suburb of the Dallas Fort Worth Metroplex (DFW) and I walked into two separate good old fashioned department stores. One housed regional retailer Dillards Inc. (NYSE: DDS) and the other was the ubiquitous mall anchor Macy’s Inc. (NYSE: M).

What I saw was illuminating. The parking lot of the Dillards store was mostly empty. When I went inside, there were few shoppers. I also noticed prices there were not widely discounted.

When I drove across to the other side of the mall, I noticed there was a full parking lot in front of Macy’s. Inside the store, there was much more traffic. Moreover, the discounts on large sections of merchandise were in the 65-70% range. They were already touting Black Friday price cuts – nearly two weeks ahead of the event. Even more interesting, there were lines at the checkout counters where the sales staff seemed genuinely pleased with the increase in business.

Here’s the take away. Both stores serve similar clienteles. Both stores are mall anchors. Yet, the difference in the number of customers in each store was stark. The difference was the discounting and front running of Black Friday at Macy’s; especially discounting of premium merchandise.

Shopping for Bargains in the Retail Sector

The VanEck Vectors Retail ETF (RTH) is a broad window into the retail stocks. Its recent price action suggests that money, moving into this area of the market, albeit in fits and starts. Indeed, the price chart’s stop and go trading pattern and my recent visit to the mall seemed to mirror one another. So, I dug into the ETF’s components. What emerged was a picture of a sector in which investors have been making outsized bets on discounters and wholesalers, while avoiding department stores. Moreover, this seems to be reversing.

Currently, there are two leading stocks in the sector: Walmart Inc. (NYSE: WMT) and Costco Wholesale Corp. (NSDQ: COST). Because of their scale, these two companies command huge market shares and are able to keep costs down by pressuring their suppliers to keep costs low, doubly boosting their earnings.

The rally in Walmart is certainly worth noting. But the stock’s steady climb shows that investors have been making big bets on the company’s ability to make money for a good while, which means it’s likely a bit late to enter the shares. Its upcoming earnings, due out on 11/16 will either confirm or disappoint investor expectations.

If history is any clue, expect better than expected results, as the company has beaten expectations for five straight quarters. Still, it’s hard to see the shares move much higher without a pause.

Costco’s stock is also on fire, as the company recently beat earnings expectations even though sales were flat, which seems to be a recurring factor with all retailers these days. On the other hand, since I visit a Costco store on a weekly basis, I have an unofficial hand on its pulse. Lately I’ve noted an increase in traffic as the Christmas merchandise is being deployed. This is compared to the reduced traffic I had noticed during the most recent quarter where the company registered a slowing of sales. I’m not seeing any discounting at Costco.

For its part Macy’s shares are near their recent lows even though they’ve managed to beat earnings expectations over the last several quarters. The stock is certainly a value, trading below 5 times earnings and yielding 5.65%. Its earnings report on 11/16/23 will likely shed further light on operations. A sustained move above $16 would signal that the worst is likely over for Macy’s.

Shares of Dillards just moved above their 200-day moving average. It trades at nearly seven times earnings and has a miniscule dividend yield of less than 1%. Its next earnings report is due out in February 2024. It has beaten earnings expectations for the past five quarters.

Value Versus Momentum

The retail sector is showing signs of a potential recovery but being selective is important. Investors should consider choosing between value such as shares in Macys and Dillards currently offer and momentum such as what’s evident in Walmart and Costco.

It’s useful to get out and kick the tires before considering buying shares of individual retailers. At this point, it’s all about volume. Thus, success for retailers will depend on how much traffic they can attract to their stores and how effective their discounting, cost cuts, and other strategies are in converting the traffic to sales while maximizing profits.

Currently, I’m more inclined to go with value. So, if I had to choose a long term potential hold based the four stocks featured in this article, Macy’s, Dillards, Walmart, and Costco, I would consider Macy’s, given its valuation and dividend yield; after analyzing its earnings report, with emphasis on its outlook and future guidance.

On the other hand, the move above the 200-day moving average for Dillards makes the stock interesting from a trading standpoint, especially since it won’t be reporting earnings for several months.

Finally, one thing is certain, Walmart and Costco are well out of consideration in the short term given their current momentum thrust. They may become interesting after they consolidate their recent gains.

A happy compromise might be owning shares in RTH, which is a diversified portfolio which is clearly capturing the upside in WMT and COST without letting other stocks in the sector drag it down too far.