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Retail Market Getting Too Ahead of Itself

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Retailers have a long, bumpy road ahead with no room for this level of optimism.

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Retail Fundamentals vs. Retail Stock Prices

Beating the S&P 500 by nearly 2.5 percentage points year-to-date, the performance of Retail HOLDRs (RTH) -- an ETF holding 19 retail companies -- gives an impression that retailers had one heck of a year.

Talk about misleading.

While the ETF has returned 26% so far this year, retailers have been positing extraordinarily weak sales figures and persistently slimmer margins. Some previously flourishing retailers have even found themselves profitless.

In other words, there's a growing disconnect between the fundamental performance of retailers and their stock prices. And at some point, the divergence between the two will have to close. Because retailers have little to no chance of notable recovery in the near future, stock prices will likely come tumbling down in the next few months.

For a quick and basic comparison, take a look at the following chart of leading retailers.



These companies have shown little to no growth -- some even very negative growth -- over the past two years. Yet, they're selling at pre-recession trailing P/E levels and have all outperformed both the S&P 500 and the retail ETF year-to-date.

All of the companies listed above are solid firms that flourished with the booming economy. But times have changed.

The target audience for Nordstrom (JWN) and Saks (SKS) quickly shrunk as consumer credit vanished. Home Depot (HD) is still caught in the middle of the lingering housing crisis. Target (TGT) shoppers have migrated to cheaper alternatives at Walmart (WMT). And American Eagle (AEO) is struggling to win over fickle teens who would rather spend the little money they now have on unique attire at Urban Outfitters (URBN) rather than buying another bland logo sweatshirt.

While I understand that the market is forward-looking, I think it has gotten way ahead of itself. The economy is stabilizing, but far from full recovery. Because the retail sector typically trails the rest of the economy as one of the last industries to recover from a recession, these companies have a long road of tough times ahead of them.

With a wealth of retail competitors and fewer dollars to go around, a rocky future still lies ahead for even those companies that were thriving just a year or so ago. Thus, the retail sector is still a very risky place to invest right now. The fundamentals and the near-term future prospects for retailers do not, in any way, suggest that these companies should be outpacing the market and these companies should be selling at discount valuations.

The market is pricing in a lot of optimism right now, particularly since it's the holiday season. Eventually, it will realize that real growth is nowhere in sight and valuations will be adjusted accordingly.

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No positions in stocks mentioned.
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