Like many investors, Ben Friedman began 2005 with serious reservations about the sustainability of consumer spending -- the primary engine of U.S. economic growth. As a portfolio manager with Dana Investment Advisors focused on equities in consumer discretionary stocks, as well as consumer staples, Friedman took a defensive stance. He looked for retailers that would succeed in serving certain niche markets, as well as companies that catered to the rich.

So far, Friedman has had a great year, no thanks to his stock-picking.

"Most retailers have done pretty well this year, because the consumer has just not slowed down at all," Friedman said. "Spending has got to dry up eventually. When the savings rate is at zero -- as it has been for some time -- there's only one way it can go: up. And when people start saving, retailers will feel it."

Because of concerns like these, retail investing has been a rocky road lately, despite steady improvements in Wall Street's economic indicators. For the most part, companies have continued to deliver earnings at or above the market's expectations, and the S&P Retail Index has gained 7.8% for the year. But while investors have shown an increasing willingness to bid up the good news, they still slam on the brakes at the first signs of trouble.

Trading action this summer offers a clear example of this psychology. In June and July, the retail sector led the stock market in a broad rally, amassing all of its gains for the year as sales figures came in strong and earnings estimates for the rest of the year inched upward.

July sales results were largely disappointing, however, reflecting the volatile nature of a month that has long been a transitional time as merchants prepare inventories for the back-to-school season. At the same time, oil prices have spiked toward an unprecedented $67-a-barrel level, and scattered reports of hiccups in the housing market have put people back on edge. So far in August, the S&P Retail Index has shed 3.8%.

"We still get reminders that the consumer's balance sheet is still loaded with liabilities," Friedman said. "People just continue to spend on credit or cash out by refinancing their mortgage, and they use that money to spend on discretionary goods."

Adding to the resiliency of consumers' spending habits, monthly employment figures have shown a pickup in job and wage growth. For July, the increase in nonfarm payrolls exceeded Wall Street's expectations, with 207,000 new jobs. Average hourly earnings were up 0.4% for the month, compared with the 0.2% gain that economists were expecting.

"If these positive employment trends continue, then people are going to continue to spend money," Friedman said. "It looks like the consumer will be OK for the remainder of this year, but looking out into 2006, I'm not so sure. A lot depends on where interest rates go, particularly on the 10-year Treasury note, since that's what affects mortgage rates."

Fueling concerns are the vast sums of floating-rate mortgages that have been issued to consumers in the low-rate environment of the last few years. The interest rates on those mortgages rise and fall with the yield on the 10-year note. Over the last 10 months, the

Federal Reserve

has sought to rein in the money supply with 10 consecutive quarter-point rate hikes, but the yield on the 10-year has not risen accordingly.

If rates should spike, eventually many consumers who have enjoyed the refinancing boom could see their interest expenses increase dramatically, and that would presumably crimp their spending power.

Despite gains in the stock market, rising corporate profits and solid economic data, consumer attitudes appear to reflect the existence of these risks to the economy. For August, the University of Michigan said Friday that the preliminary reading of its consumer sentiment index dropped to 92.7. Economists expected a reading of 96.0 in the preliminary reading after the final July print of 96.5.

Also, the latest reading on the Conference Board's consumer confidence index showed a decline in July, down to 103.2 from 106.2 in June.

As a hedge against rising rates and spiking oil prices, Friedman likes retailers geared toward serving high-end consumers who are well-insulated from the threat of rising costs.

"If the price of gas goes up to $2.50 a gallon, that's not going to affect a rich person nearly as much as a poor person," he said. "Plus, more affluent people's jobs have been more stable."

For exposure to high-end consumers, Friedman likes

Nordstrom

(JWN) - Get Report

, a department store chain whose shares have added 38% this year, though they've shed over 13% over the last two weeks.

He cites Nordstrom's growth prospects, along with recent upgrades in its inventory supply management, as supporting his bull case on the stock.

Elsewhere, Friedman owns shares of

Michaels Stores

(MIK) - Get Report

, a chain of arts and crafts stores whose shares are up 27% for 2005. They, too, have dropped recently, down 7.8% in August.

Michaels has also recently built a more sophisticated inventory system, providing expansion opportunities for its profit margins. And Friedman thinks they serve a growing niche of customers.

"Their stores are getting popular for women who are into building scrapbooks and stuff like that," Friedman said. "These days, I like smaller companies that have found some sort of sweet spot between the

Wal-Marts

(WMT) - Get Report

and

Targets

(TGT) - Get Report

."

Friedman works in Dallas, but his firm is headquartered in Milwaukee. It has $2.5 billion in assets, with about $800 million of that in equities. The rest is in fixed income.