When Consumers Pull in Their Horns

08/11/2010 12:00 pm EST

Focus: ETFS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, says retailers will take a big hit as consumers retrench, and he suggests one way to profit from their coming misery.

Everything is normal: Europe clearly faked its bank stress tests, June US new-home sales were the second worst on record, and jobless claims were higher than estimates. The bad economic news and reports just keep going on and on.

There is new data which strongly reinforces our position on housing and consumer spending.

[A recent University of] Michigan consumer confidence survey was down for the third month in a row. The fall in confidence is down to 50.4—when it's below 50, the consumer is saying "things are going to get worse—and is based on a view of the real world many on Wall Street don't see.

In addition, the latest consumer spending survey from ChangeWave Research released [last] month showed a "major pullback in US spending behavior going forward, coupled with a continued deterioration in consumer sentiment and expectations."

The survey also pointed to a slowdown for several spending categories, including travel/vacations, restaurants, electronics, and consumer durable goods—as well as weakness for key discount retailers Costco Wholesale (Nasdaq: COST), Target (NYSE: TGT), and Wal-Mart Stores (NYSE: WMT).

How are we going to play this?

The obvious first stop for us (and Wall Street when it catches up with this data) is retailing.

One, there was a slowdown in electronics and home durables—the big-ticket items that impact overall retail sales data that drives trades.

Second, back-to-school [season] is upon us, and a disappointing sales season—which the survey is predicting—will give us an immediate tailwind behind our retailing positions.

Retail shot up sharply, as a segment, for many months in anticipation of a recovery and because most retailers are quite well managed and have the ability to ruthlessly cut costs in a relatively short period of time.

The best way to play the segment is through puts on the SPDR S&P Retail ETF (NYSEArca: XRT). XRT covers the entire segment and includes many of the retail chains that will feel the pullback the most: clothing, specifically teen and women's clothing.

It also has the broadest base and is the least susceptible to success at the very low end of the market by companies such as Wal-Mart or Dollar General (NYSE: DG). No position is more than 1.85% of the ETF.

I'm recommending the SPDR S&P Retail ETF January 2011 35.00 Puts (XRT 110122P00035000) with a Buy Under price of $2.15. Please use tight limit orders and don't chase this. (XRT closed at around $38 Tuesday, and the puts traded at $2.11. Buying put options and shorting stocks in general is only for very risk-tolerant investors who can afford to lose the money they’re putting in—Editor.)

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