RealMoney Silver - Don't Chase a Retail Rally

Don't Chase a Retail Rally
By Tim Melvin
RealMoney.com Contributor
3/5/2008 1:21 PM EST

After hitting 1388 on Feb. 27, the S&P 500 (SPX) has quickly pulled back from the approaching 1400 level and is moving speedily toward the 1300 mark. Continued bad news out of the financials, a Fed chairman who seemingly loves to talk down the stock market, and a total lack of leadership have all combined to push prices lower on a daily basis.

We are getting near the levels where even I would consider a bear market rally a real possibility, if not a probability. If we go below 1300 with a VIX reading over 30, I will probably take a shot at short-term index longs. If I do, I will post them here or in Columnist Conversation. I am getting jealous of Doug Kass and his very accurate trading calls, so I am going to have to make one of my own soon. No way can I let a Yankees fan have the upper hand.

Will a rally off this bottom mark a real low and a change on my overall market outlook? Unfortunately, in my opinion, no. The current problems are not going away: Citigroup (C) and several other large financial institutions have more write-downs on the way in the first quarter; the student loan industry is a wreck and probably going to get worse long before it gets better; retail is weak and will get much weaker in my opinion. And the looming specter of $4 gas and climbing food prices is scaring consumers into inaction.

Don't expect cash-rich corporate balance sheets to save the day. Businesses are preparing to hunker down and ride out this part of the economic cycle. Everyone wants a government bailout to fix the financials, restore the homeowner and recreate the municipal bond insurance market.

Never mind that it is not the role of the federal government to fix these problems, nor are there enough resources to actually fix all the problems without creating new inflationary pressures. The market is just going to have to work through the situation and that should mean lower prices ahead. We will probably rally back to the top of the trading range but then the bear will take over once again, in my opinion.

This should set up some interesting trades. One of my favorite stocks to sell here would be Abercrombie and Fitch (ANF) if the stock rebounds back above $80 a share. Some bullish investors think ANF's popularity with the younger set should provide some insulation from recessionary pressures. I disagree.

I also think analysts' estimates for 2008 for ANF are way too high, and I predict major earnings misses over the next 12 months.

The younger generation buys gas and eats as well. My 23-year old daughter would cheerfully starve for a new outfit. But as the cost of putting gas in her car and her regular infusions of super double frappe lattes eat into her budget, she is learning about stores like Marshalls (TJX) and Charlotte Russe , (CHIC) where she can save a few bucks on clothes and necessary accessories.

The same logic hold true for shares of Urban Outfitters (URBN) if the stock rallies above $30 a share.

I think that some of the causal dining stocks are in for a rough road as well. If you are struggling with your mortgage and rising food costs, a trip to a local eatery with the kids might need to be curtailed. Cracker Barrel (CBRL) seems particularly vulnerable to me.

The company has skinny margins and carries a lot of debt on its balance sheet. In fact, it has one of the lowest interest-earned ratios in the industry. It could quickly feel pain if sales and margins begin to slip further. Cracker Barrel's restaurants, which are often situated right at highway exits, could be see a slowdown in traffic if higher gas prices crimp travel this summer.

Shares of Cracker barrel have risen 50% in the last two months, an unsupportable move in light of the above-cited concerns.

My other sell selection in this group would be Chipotle Mexican Grill (CMG) . I know business appears strong right now, but it's a taco stand with clean floors selling for 45 times current earnings and more than 35 times the 2008 estimate. A weak economy is bound to lead to operational stumbles. The stock has come down in recent months, but I think it has farther to go.

Two caveats with all of these ideas. First, I am only selling if there is, in fact, a bear market rally. Second, I am a chicken short and always use put spreads with my positions so I have a limited predefined loss. I use a debit spread, buying at or near-the-money puts and selling a lower strike. My profit is limited to the difference between the strikes and what I pay for the spread but the loss is limited to the net premium paid. I usually try to get a 2/1 risk/reward ratio at a minimum to put the trade on or I just won't do it.