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These Retail Stocks Could Use a Rate Cut

Tim Arango

Are lower interest rates enough to quell concerns about a consumer spending downturn?

That is the central question investors face when weighing whether to pile in to retail stocks amid a period of easing interest rates. The Federal Reserve announced a surprise interest rate cut Jan. 3, and will gather Tuesday and Wednesday for a meeting widely expected to result in a further slashing of borrowing costs. And along with financial services stocks, retailers generally perform well in times of falling interest rates.

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"Anytime you get the Fed cutting rates, it particularly helps retail stocks," says Ryan Crane, who manages the $850 million (GTSAX Quote)AIM Small Cap Growth fund. "Consumers feel more comfortable spending money." The theory behind it is twofold: Lower rates put more money in consumers' pockets through savings on everything from credit card bills to mortgage payments, and companies pay less to service their debt, reducing costs and bolstering profits.

Rally Caps

Many retail stocks have rallied in recent weeks on anticipation of further Fed action, and analyst upgrades -- the most prominent being a recent Goldman Sachs report -- of battered retail stocks have become an almost daily occurrence. In addition, many analysts have moderated their views that a recession is on the horizon, and now most expect a rebound in consumer spending by the second half.

J.C. Penney (JCP Quote) and Target (TGT Quote) were the beneficiaries of analyst upgrades Monday. J.C. Penney was off 23 cents at $13.72 Tuesday after gaining Monday on the heels of an upgrade by Bear Stearns. Target was up 9 cents at $36.94 Tuesday after the upgrade by U.S. Bancorp Piper Jaffray.

There's some thinking on Wall Street that the retail move is overdone as it is, and that further rate cuts shouldn't spur additional gains. "We basically think that the fact interest rates are going down is already priced in to the shares," says Anu Kothari, a retail analyst at State Street Global Advisors.

History, however, suggests otherwise.

Consider this: According to an analysis by Sam Stovall, senior investment strategist at Standard & Poor's, retail stocks reap strong gains for at least six months after initial interest rate decreases. In looking at all rate cuts since 1971, Stovall concluded that the best-performing sector is consumer staples -- which include drug stores and food chain stocks -- rising an average of 16.2% in the six months following a cut. The consumer cyclicals sector, which includes department stores, apparel companies, footwear and general merchandise stocks, is also a strong performer, having risen an average of 13.9%.

Who Makes Out

Lee Backus, an analyst at Buckingham Research, says department stores are in a particularly good position to benefit from lower rates. His pick is Federated Department Stores (FD Quote), a company that has been plagued in the past by credit worries. The company has a large amount of debt, Backus says, which will be easier to service in a time of lower interest rates. Backus has a strong buy on Federated and his firm does not do underwriting.

In addition to Federated, he is bullish on fashion vendor companies that supply department stores, stocks like Ralph Lauren (RL Quote), Jones Apparel Group (JNY Quote), Tommy Hilfiger (TOM Quote) and Liz Claiborne (LIZ Quote). Backus rates Jones and Ralph Lauren strong buys, and has buy ratings on Tommy and Liz Claiborne.

Peter Caruso, an analyst at Merrill Lynch, sees steep markdowns at many retailers, in particular Home Depot (HD Quote), as strong evidence that much lower interest rates are forthcoming. He recommends so-called hardline retailers: Home Depot, Lowe's (LOW Quote), Best Buy (BBY Quote), RadioShack (RSH Quote) and Toys R Us (TOY Quote).

Investors should keep in mind that the benefits of lower rates take time to seep through the economy. Remember, the current slowdown is the result of a campaign of interest rate increases begun some 19 months ago.

But when it comes to the stock market, betting on the future is the name of the game.