For Retail, Book Still Open on 2004

If chain stores stall before Christmas, it bodes badly for the coming year.
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Retail stocks are marching into the homestretch of a banner year, but failure to navigate a particularly thorny holiday selling season could set the stage for upheaval in 2005.

The S&P Retail Index has gained 25% since early August and is up a healthy 19% this year. The sector has blown away the broader market, with the

S&P 500

recently up just 7% since Jan. 1.

Wall Street expects a repeat in 2005. Thomson First Call estimates that the Dow Jones Retail Index will post a year-over-year gain of 16.7% in earnings in 2005 vs. 15.5% in 2004. The S&P 500 is set for earnings to slow to 10.6% growth in 2005 from 19.1% in 2004.

While this year is shaping up to be a success, holiday sales, yet to be reported, could still make or break the annual profit performance of many retailers. So far, the yuletide shopping bonanza has been marred by some Grinch-like numbers, and economists say a weaker-than-expected holiday could foreshadow deeper problems for the very consumers whose pocketbooks keep retailers afloat.

"You can make a much stronger case that retail results are more likely to surprise on the downside than they'll surprise on the upside," said Ken Goldstein, economist with the Conference Board, an independent economic watchdog group.

A recent report from the government showing that November retail sales rose 0.1% was better than economists expected, but it did little to improve sentiment dampened by a string of sales disappointments from individual companies. Retail stocks drooped on the news, as traders concluded that a 0.1% gain was a lousy excuse to celebrate going into the holidays.

"The gain in sales in November wasn't bad, but it certainly wasn't anything to brag about, and even that was accomplished with a fair amount of discounting and promotions," Goldstein said. "Now the expectations are for 4%. Last year, 4% represented a lousy year. This year it's the same, but the adjectives being used are a little bit different, and I think that's kind of curious."

Goldstein said the holiday results would likely be "OK, not great," but he is mostly concerned with consumer confidence going into 2005. The Conference Board's consumer confidence index has fallen for four straight months while its index of leading indicators has fallen for five, and Goldstein thinks sluggish growth in the job market is the root of the problem.

"Consumers have been waiting for the labor market to really turn it on," Goldstein said. "The numbers haven't really been that bad. Hiring has been average to weak, where consumers have been waiting for average to strong. At this late date in the economic recovery, these numbers just aren't cutting it."

To be sure, since the economic recovery started producing job-market gains on a regular, monthly basis in September of 2003, the government has recorded only a few scattered months of robust growth that economists viewed as really healthy. The economy has failed to average over 200,000 new jobs a month the way it did for most of the 1990s, and the recovery is over three years old.

Without more vigorous job growth in the near future, Goldstein worries that consumers might abandon their long-held belief that good times are around the corner -- and rein in their spending. A terrorist attack or more instability in Iraq would only exacerbate cautious sentiment.

"We're right at the cusp, in a sense, of where consumers have continued to believe that the labor market is indeed going to start to move," Goldstein said. "It hasn't, and we're now approaching a time when consumers could stop believing, and the consequence of that, at the same time when pricing power is starting to come back while income growth is not, could be a slowdown that will not just be a one-month or two-month phenomenon."

A host of secondary factors, aside from the job market, support an argument for caution. The low-interest-rate environment that encouraged consumers to borrow is ending, and oil prices, though down from record highs, are still steep by historical standards. That will eat further into consumers' spending budgets this winter, particularly those of the lower-income population, which is more sensitive to such factors.

"Refinancings are beginning to slow, and that was a huge cash stimulus to the consumer's balance sheet, so now they have a lot less money available to spend," said Ben Halliburton, principal and managing director with Traditional Capital Management. "Savings rates have slowed down to near 0%, so the consumer is definitely getting a little stretched. We think retail is likely to underperform in 2005."

The world's largest retailer,


(WMT) - Get Report

, has already shown itself vulnerable to a crimped consumer. The company posted a 0.7% rise in same-store sales in November and lowered its forecast for the fourth quarter to 1% to 3% from its old estimate of 2% to 4%. The report followed a string of monthly sales results that came in significantly lower than Wal-Mart's historical gains of 4% to 6%.

Elsewhere, two of the sector's biggest gainers,


(S) - Get Report




, have benefited from speculation about their real estate assets, not the strength of their business. While the companies have logged lackluster sales gains all year, investors were wooed in 2004 by Ed Lampert, the hedge fund guru with ESL Investments who masterminded the merger of the two struggling retailers. Sears is up 18% for the year, while Kmart has added a cool 329% after emerging from bankruptcy in the spring of 2003.

Other retail winners in 2004 include

American Eagle Outfitters


, up 169% for 2004 thanks to its popular teen fashions.

Urban Outfitters

(URBN) - Get Report

has gained 131% on the basis of outstanding sales results, and the same goes for

Abercrombie & Fitch

(ANF) - Get Report

, up 82%. Overall, apparel retailers have shown widespread weakness.

Out of favor with investors after questions about its accounting practices,

Krispy Kreme


set the bar on the losing end of 2004, down 73.1% for the year. Other sector losers include

Hot Topic


, down 45.6%, and


(TIF) - Get Report

, down 34%.

If a consumer slowdown causes problems for more retailers in 2005, weakness could spread to the broader economy as consumer spending accounts for roughly two-thirds of all economic activity in the U.S.

"If the consumer is weak, businesses are unlikely to spend money on capital goods to expand their capabilities," Halliburton said. "We think that 2005 will be a modest growth year, somewhere in the 2% to 2.5% GDP growth level because of consumer weakness. The other issue is that the potential for falling back into recession is more likely, so you have a more precarious economy because of the extended leverage of the consumer."

On a more positive note, while he thinks consumers could drive a first-half slowdown in 2005, Goldstein said there is a real possibility that the stars could finally align for the economy later in the year.

"You could see a very quick turnaround," Goldstein said. "Maybe by the second half of the year, you could have a situation where investment picks up as consumption and exports pick up, and you could wind up with a real pop to the economy.

"Whatever this is that we're in, both in terms of consumers worrying and businesses being cautious, if anything can turn that around, it's pricing," he added.