Shop Smart in Retail

This column was originally published on RealMoney on Oct. 9 at 1:23 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Retail stocks surged higher early last week as investor optimism about September sales infected the ticker tape.

Those hopes were fulfilled as strong monthly numbers were reported Thursday morning, but there was a selloff on the news, and a broad variety of issues fell into unexpected downdrafts.

We're in a speculative period ahead of the 2006 holiday season.

This is the time when large capital flows ripple through the sector, hunting for the year's winners and losers.

This dynamic should wind down ahead of the December sales peak as traders shift attention to next year's opportunities and dangers.

This year's stock-picking season has been more intense than usual because the tape has been fueled by a growing belief that consumers will spend more money as the interest-rate environment improves.

Of course, no one really knows if this is fact or fantasy, so it's the perfect time for charting levels to dominate the price action.

Retail HOLDRs (RTH Quote) has been running higher since its July low, but it is now approaching strong resistance at $100.

Note how this price level has triggered several reversals in the last two years.

The holiday period is approaching quickly.

This convergence suggests the current uptrend will stall out as traders wait for more sales data.

Resistance is resistance until it becomes support.

In other words, it's not wise to bet on a breakout in this issue until (a) it happens, or (b) it hovers near $100 and refuses to sell off for a number of weeks.

My advice is to avoid the instrument entirely until the price action shows its hand.

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Last week's rally retraced the boundaries of a three-week trading range. This sideways pattern contrasts with growing hype about the sector's recent progress. It might also mark the start of a broad topping pattern, triggered by overhead supply, but I doubt the current uptrend will fail until it surges to the big $100 level.

With resistance firmly in place, retail is likely to be a stock-picker's sector during the fourth quarter. Take the time to identify top prospects rather than throwing money at poor performers or overstretched leaders.

The following handful of stocks should produce superior gains between now and the end of December.

Let's start with department stores. Thursday's data triggered a mixed reaction that was exasperated by a concurrent Kohl's (KSS Quote) downgrade. While the majority of mall giants beat consensus numbers, Dillard's (DDS Quote) sold off after reporting poor monthly traffic. Rather than toss up a chart, let's just agree this stock should be avoided right now.

Kohl's still looks good, despite last week's downgrade. After Bear Stearns dropped its rating, the stock hit a three-year high Wednesday and gapped down. However, the selloff never broke support, so it should resume its uptrend after a short consolidation. The real work for the issue will come if it rallies above its recent high of $69.25.

Looking backward, there's a gantlet of 2002 highs between $70 and $78. This is considerable supply that predicts slowing progress as the stock rises into those levels. But Kohl's remains a group leader, so I'm looking for it to reach the upper end of the boundary before the year's end. That would mark a good place to take profits.

Federated Stores (FD Quote) surged to new highs on Sept. 27 after Carl Icahn announced he was buying a huge chunk of shares, but the stock subsequently dropped into a triangle pattern, with resistance over $44. Note how it hardly budged after last week's data although the company reported a 6.2% sales gain.

Upside momentum should increase sharply after the stock takes out short-term resistance. That move would start the next leg in a rally that has shown little or no weakness since it began in July. Given this stock's unique circumstances, we could see a rapid advance to $50 and beyond.

Let's look at TJX Companies (TJX Quote) in the longer-term view. The stock hit a peak in 2004 and dropped into a broad consolidation pattern. It rallied back to the high in mid-August, tightened against resistance for four weeks and then broke out on very strong volume. That event should mark the start of an uptrend that lasts for months.

The stock has moved up just 2 points since the breakout, so there's still plenty of time to get on board. Of course, I'd rather buy it on a pullback to $27, but nothing in the pattern suggests that's happening right now. That might change once it approaches $30, though, because the big round number could attract profit-taking.

I'll follow up on Tuesday with another list of my top picks in the sector.