Rally's Key: Intersection of Consumer and Energy

The year-end rally is on pace, but retail spending may not live up to rising expectations.
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'Tis the season to be merry. But is it too early?

Wall Street is still banking on the traditional fourth-quarter rally, which is often powered by strong holiday sales. But this year's holiday cheer, evident in the recent bounce in stock prices generally and the retail sector in particular, might be running ahead of consumers' spending plans.

For investors, it's all a matter of timing and of understanding the market's expectations. For example, after Hurricane Katrina led to a plunge in consumer confidence in September, traders were braced for the worst; they were therefore heartened when October chain-store-sales came in stronger than expected.

Meanwhile, energy prices have continued to correct amid unusually warm temperatures for the season, with crude oil dipping below $59 per barrel on Monday. Lower gasoline and natural gas prices as well as friendlier weather augur favorably for retail spending.

(In other retail-related news,

TheStreet.com's

Troy Wolverton looks at the holiday outlook for makers of

consumer electronics while

Nat Worden takes a look at

Federated Department Stores'

(FD)

prospects.)

"Sure, the spending outlook is positive. With the country warmer right now, energy prices leveling off and people adjusting their behaviors towards energy utilization, spending will go on," says Richard Hastings, a retail analyst with Bernard Sands. "Holiday seasonal patterns are not as clear as they used to be as the climate is not varying as much,

but people start spending earlier and in different ways."

This cheerful outlook seems to be gaining ground on Wall Street. After hitting a six-month low of 421 on Oct. 27, the S&P Retail Index has since rebounded 8.8%, including a 0.7% gain on Monday when the

Dow Jones Industrial Average

advanced 0.5%, the

S&P 500

rose 0.2% and the

Nasdaq Composite

rose 0.4%.

"It's hard to bet against the American consumer and it's very hard to break stocks down in November and December," says Jeffrey Saut, Raymond James' market strategist.

Of the past 15 fourth quarters, 13 have produced positive returns for stocks, he notes, with the two exceptions being 1994 and 2000.

But given that one of Saut's mottos is to "assume the best and prepare for the worst," he doesn't find too much comfort in those statistics -- especially as Wall Street seems to be pricing in a strong retail season and behaving as if the year-end rally is a given. "The reality is we're going to see a somewhat muted holiday shopping season," Saut believes.

Even if consumers overcome still-high energy prices and a slowdown in the rise of home equity levels, retailers are not necessarily going to be cashing in as much as in previous years. "If you go into a mall, you'll notice all the pre-holiday sales and discounts at the

Nordstroms

(JWN) - Get Report

and

Dillard's

(DDS) - Get Report

of the world," Saut says. "These guys are preparing for the worst."

Concerned that consumers may be less willing to jump in the car to go shopping than before,

Wal-Mart

(WMT) - Get Report

has been leading the charge in aggressive pricing.

According to Lehman Brothers retail analyst Alan Rifkin, "Wal-Mart has indicated that it will revert to aggressive promotional behavior this holiday season," including in the consumer electronics segment, which is usually a key driver of holiday sales. This does not bode well for the likes of

Circuit City

(CC) - Get Report

and

Best Buy

(BBY) - Get Report

.

Retailers "will be forced to increase promotional activity in tandem, which could likely result in compressed margins," Rifkin wrote in a research note.

Aggressive pricing and sales incentives by

General Motors

(GM) - Get Report

and

Ford

(F) - Get Report

last summer helped the auto industry delay its problems (and its impact on the economy) until the fall. Similarly, aggressive pricing by retailers could save the shopping season and, by extension, the broader fourth-quarter rally.

The real test will come in two weeks with the Thanksgiving holiday and more specifically, Black Friday, according to Saut. Stocks "can move up until Thanksgiving and if the sales come in stronger than people think, then the rally can continue."

But rising market expectations of retailers' performance are only raising the bar for the rally. Along the same lines, the ongoing drop in energy quotes, which have further raised Street expectations for a happy retail season, may not be as favorable for the rally.

First, the energy sector is showing signs of responding to the drop in energy prices. The Amex Oil Index dropped 1.8% to 977.77 on Monday as oil fell below $59; weakness in the energy stocks weighed heavily on the S&P 500.

This brings us to the second point: It's largely the energy sector's surge that has led the broad market higher over the past two weeks. As

detailed last week, the energy sector first corrected ahead of earnings reports and then rebounded somewhat after the blowout results. But now that it seems earnings in the sector can't continue soaring as they have in the past, investors are reconsidering those bullish bets.

After rebounding 12.2% from a low of 912 on Oct. 20 to 1023 on Nov. 3, the Amex Oil Index has since fallen back 4.5%.

If energy shares continue dropping along with energy quotes, that may prove to be a large hurdle for the year-end rally, at least as far as the blue-chip averages are concerned.

On the other hand, if crude oil prices and energy shares were to rise again because of further signs of economic growth, it would make sense for the market and energy to move higher in tandem. But if energy quotes rise because of a cold snap, that won't spell good things for retail stocks, the economy or, very likely, the year-end rally itself.

In sum, weather reports might become more important than economic data over the coming weeks.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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