An in-depth look at the retail sector's recent stellar performance clearly shows the work of the invisible hand.

Regards - VHF

-

Retail’s Dirty Little Secret

Graham Summers

March 24, 2010

Anyone looking to understand how the market works today should take a look at the retail sector’s recent performance. Last time I checked, the retail sector needed people to spend money in order to be profitable. And yet, amidst a backdrop of high unemployment (or underemployment), $80 oil, depreciating home values, and increased health care costs, the retail sector has somehow managed to EXPLODE HIGHER in the last few days.

The above chart compares the performance of the Retail ETF (IYR) to that of the S&P 500 (GSPC). As you can see, Retail has TROUNCED the general market in this latest rally, moving up nearly 20% in roughly one month’s time.

Before delving into the cause of this lunacy, let’s delve into some background facts. The consumer accounts for 70% of US GDP. Real unemployment is currently close to 17%. Food Stamp usage is around a record 38 million. February’s individual tax receipts are down $8 billion from 2009’s already multi-year low level of $38 billion (wasn’t February 2009 when everyone thought the entire world was ending?).

And yet, retail stocks are only about 10% below their pre-Crash 2008 levels:

If you feel as though your head is about to explode, you’re not alone. Unfortunately, when you look at individual retail stocks’ charts, the situation becomes even more insane. Let’s take a look at Gap (GPS).

Gap sells clothing and accessories under the Gap, Old Navy, and Banana Republic brand names. Believe it or not, Gap’s stock is actually HIGHER now than it was BEFORE the Financial Crisis. That’s right, GPS shares are actually higher than they were back in 2007. It’s as though 2008 NEVER happened.

Now, on the surface, there appear to be some reasonable explanations for why GPS is soaring. Firstly, in October 2009 the company began posting its first increases in same-store sales in more than three years. In addition, while sales are down year over year, the company actually managed to increase profits from their 2008 levels.

Sounds pretty good on the surface.

However, there are a few questionable items lurking in this success. For one thing, MOST of the comp store gains are coming from Old Navy, GPS’s lowest cost franchise. In contrast, Banana Republic and Gap (its more expensive lines, are posting negative growth are flat, or showing VERY low growth from 2008 levels).

Furthermore, there are snippets like these:

For the Stores reportable segment, our net sales for the third quarter of fiscal 2009 increased $14 million, or 0.4 percent, compared with the prior year comparable period. The increase was primarily due to an increase in net sales at Old Navy and the $15 million favorable impact of foreign exchange, offset by a decline in net sales at Gap and Banana Republic. The foreign exchange impact is the translation impact if net sales for the third quarter of fiscal 2008 were translated at exchange rates applicable during the third quarter of fiscal 2009.

So here we see $14 million in profit on a favorable $15 million foreign exchange rate (using 2008 profits at 2009 level exchanges). Remember, the US Dollar was on a tear in late 2008 vs. a 16% loss for the year in 2009. So in plain terms, this gain means that most of GPS’s profits came from Dollar devaluation and currency rates, NOT organic sales growth.

Now, roughly three quarters of GPS’s sales come from the US, so it’s interesting to note that EVERY brand except Old Navy has posted significant drops in sales from 2008 to 2009.

I want to stress that 3Q08 was when the entire financial system nearly imploded. This was literally an “end of the world” retail environment… and GPS’s sales are largely DOWN from those levels. And yet, GPS shares have broken to levels even higher than they were in 2007, BEFORE the Financial Crisis even happened.

On a final note, if GPS has a bright future and is properly valued, GPS insiders certainly don’t think so. They’ve dumped 5.7 million GPS shares in the last two years alone (that’s about 3% of the company). In fact, you’ve got to go back to before March 2008 to find a single time someone who worked for Gap bought its stock.

I haven’t done enough research on other retailers, but I would assume similar accounting gimmicks and shenanigans exist throughout the sector. The basic logic for this business model is that you need consumers to actually buy stuff to make money. And yet, despite sales falling even from 2008’s abysmal results the retail sector has been one of the top performers in the market as of late. If you’re looking for some potential shorts once the market finally rolls over, this sector should be ripe with opportunity.