Retail Sector Watch
(June 7, 2004)
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The Retail Sector: As my readers may remember, we ended our
discussion of the bank sector last week with the conclusion that while bank
stocks look overvalued (absolutely and relative to the overall market) it is
still too early to conclude that they have topped out - the major reason being
that despite higher rates, the average American can still choose to borrow more
money if he or she has the capacity to do so. Whether the average American has this capacity is a
difficult thing to gauge. I also
did not like the fact that every financial writer and the next door neighbor
was calling for a top in bank, mortgage, and homebuilding stocks. If the Fed chooses to let short-term
rates remain low, then these financial institutions will ultimately even have a
larger profit margin.
In this commentary, I will attempt
to measure this capacity of the average American to borrow or spend more money,
and hopefully, I will be able to do it in a simplistic but convincing way. Please note that this analysis is all
the more important since consumer spending makes up approximately two-thirds of
GDP, and a significant stock market top rarely comes without at least a
temporary exhaustion in consumer/retail spending.
Following is a two-year chart of
the Retail Sector - which represents an objective gauge of how tapped out the
stock market thinks the average American is:
It is still too premature to be
calling for a top in the retail sector - even though the market has been quite
unsure of itself in recent months.
The fact that the Retail HOLDRS (RTH) is still above both its 50-day (91.50)
and 200-day (90.97) moving averages is an encouraging sign. A resumption in its uptrend would be
confirmed with a close above 95.75 - its recent closing high made on March 1.
Now, let's look at relative strength. The following is a weekly chart of the Retail
HOLDRS vs. the S&P 500:
Based on the above relative
strength chart, it is also too premature to call a top in the retail
sector. Again, please keep in mind
that since consumer spending makes up two-thirds of the GDP, there will most
probably be no broad market rally unless the retail sector participates as
well. An encouraging sign of a
sustainable market uptrend will be for relative strength to break out above its
March 22nd high.
Finally, in terms of sentiment, I
believe the following is a very powerful chart - a chart that spells a thousand
words and which I believe probably overrides the two charts that I mentioned
earlier. I got the idea of creating
the following chart after attending a talk by Mr. Richard McCabe, Chief Market
Strategist at Merrill Lynch earlier this year.
The above is a monthly chart of
U.S. Consumer Confidence vs. the level of the Dow Jones Industrials from
January 1981 to May 2004. Please
note that I (like Mr. McCabe) am using the level of Consumer Confidence as a
contrarian indicator - which historically has been a very reliable thing to
do. The argument goes something
like this: If consumer confidence is high, then the outlook of retail investors
on the U.S. economy is also high - resulting in more purchases of stocks by
retail investors. A consumer
confidence level that is overextended should also translate into an
overextended condition in the stock market - thus resulting in a top. While a high level of consumer
confidence does not necessarily mean a top in the stock market, please note
that every stock market top in the last 20 years has been accompanied by a high
reading in the level of consumer confidence. It is also interesting to note that even at the top of the
bear market rally during March to May of 2002, the level of consumer confidence
was over 110 - far higher than today's reading of 93.2 (and January's
The author's opinion: Despite high
debt levels, the average American is most probably not tapped out yet. Also, despite a huge run-up in stock
prices in 2003 and high valuations, a top in the stock market will probably not
materialize until the level of consumer confidence is over 110. Since the author believes that we are
in a very strong cyclical bull market (within a secular bear market), the
author will not start thinking about a potential top (and not do any shorting
-- except for hedging purposes) until consumer confidence has hit a higher
level - probably at 115 or so (where it was in October 1987 and very close to
the June 2001 level).
Henry K. To, CFA