Despite strong underlying economic fundamentals, the retail sector continues to underperform, writes Landon Whaley.
We initially recommended shorting the retail sector on July 23, 2018, and profitably traded it for the first half of 2018. However, 2019 has been a different story altogether as investors have seemingly forgotten the plight of the U.S. retailer! While retail stocks have yet to “catch down” to their Fundamental Gravity reality, we continue to think there is plenty of downside from current levels.
The overall trend in retail sales to start the year is “herky-jerky.” After bouncing from December’s recessionary 1.6% growth rate to 2.9% in January, headline retail sales growth fell back 2.2% in February. Now, based on the March retail sales report, headline sales growth has once again bounced. Despite this one step forward, one step back dance, the intermediate-term trend in retail sales is crystal clear: after peaking at 6.6% in July 2018, retail sales growth has been in a persistent downtrend, making a series of lower highs, and slowing in five of the last eight months.
More importantly, the retail sales control group is showing a similar preference to head south. If you’re new to our research, you may be wondering “what the heck is the retail sales control group?” The control group’s annual growth rate is the most critical aspect of any U.S. retail sales report because it’s used in the actual calculation of U.S. GDP. Yet despite the high information ratio embedded in the control group’s growth, the Old Institution routinely ignores it. Luckily for you, we don’t and can report that the control group’s growth rate also bounced slightly in March but has persistently slowed since peaking at 5.5% last July.
We’ll be the first to admit that the choppy action in retail sales to begin 2019 doesn’t give us much clarity on what’s likely to come next. However, the picture in bricks and mortar retailers couldn’t be more vivid.
Shut it Down!
The last couple of years have not been kind to the U.S. retailer, and it appears that the retail nightmare is only just beginning.
According to Real Deal, 5,994 stores have now closed in the United States this year, which is already more than last year‘s total of 5,864. In addition, mall vacancy rates accelerated in the first quarter to 9.3%.
S&P Global is forecasting that approximately 12 of the 136 retailers that it analyzes will default this year. If their call that almost 10% of all U.S. retailers will default in the next eight months isn’t eye-opening enough, it would be four times the average annual default rate.
Beyond this year, UBS expects 75,000 more stores to close by 2026. UBS also believes that over the next seven years, online shopping will make up 25% of all retail sales, compared to roughly 16% currently. If their forecast is even remotely accurate, it’s the death knell for the bricks and mortar retailer. Online sales don’t have nearly the profit margin of sales made out of a storefront. In fact, for most retailers, the difference between online sales and in-store sales can mean as much as 10% less net profit hitting the bottom line. If this online shift occurs, it will cripple the earnings power of U.S. retailers.
Never forget that this “retail apocalypse” began during the second longest expansion in U.S. history and the best labor market we’ve seen in more than 40 years! If these companies can’t sell stuff and make money when people are gainfully employed, and the economy is breaking historical records, what are they going to do now?
The Bottom Line
While the demise of the retail industry is readily apparent to anyone with a pulse, it isn’t reflected in the price action of retailers this year. The SPDR S&P Retail ETF (XRT) is up 11.8% year-to-date, but that double-digit return is a bit misleading. The entire gain occurred in the first seven weeks of the year, XRT has gone nowhere since Feb. 20.
The sideways price action of XRT nicely compliments the “one step forward, one step back” dance of retail sales growth and it also stands in sharp contrast to the brand new all-time highs minted by other U.S. equity markets including the S&P 500, the Nasdaq 100, consumer discretionary, consumer staples, REITs and utilities.
As with our U.S. shift work macro theme, there have not been any economic data points or financial market developments that have challenged the viability of this macro theme. The May playbook remains the same: be opportunistically short of U.S. retailers, or out entirely.
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