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Historically, retail stocks perform well in the fourth quarter because of holiday shopping trends. However, retailers don't always finish the quarter with gains, particularly when the economy is slowing.

For example, the SPDR Select S&P 500 Retail ETF  (XRT)  is up in seven of the past ten fourth quarters. However, it fell 19% in Q4 2018, the last holiday season when the Federal Reserve was hiking rates. The broader SPDR Consumer Discretionary ETF  (XLY)  has a better track record, posting gains in nine of the past 10 fourth quarters. However, like the XRT, it bucked its bullish trend when it fell 15% in 2018.

Will the overarching bullish trend for the holidays hold this year, or do similarities to 2018 mean that retail stocks are in for a reckoning?

Budget tightening makes this year a toss-up 

Retail stocks have been climbing walls of recessionary worry recently. However, performance varies among retail stock ETFs. The more diversified ETFs have done well, but funds concentrated in fewer names and with larger exposure to big-cap retailers have lagged.

For example, the XRT owns nearly 100 retail stocks, and its biggest holding -- Gap -- only comprises 1.3% of the fund's assets. So far, the XRT is up about 18% this quarter, outpacing the S&P 500's 13% return.

Alternatively, VanEck's Retail ETF  (RTH) , which owns just 25 stocks, and the XLY, which owns 56 stocks, are underperforming, mainly because of concentration in large-cap retail stocks. For instance, Amazon accounts for roughly 20% of assets in both funds.

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The hit-or-miss returns for these ETFs are concerning, but more discomforting is that much of the anticipated increase in retail spending this year is due to higher prices rather than demand growth. In Morning Recon last week, Real Money’s Stephen Guilfoyle wrote:

“The National Retail Federation is expecting holiday sales to rise 6% for November and 8% for December this year. When factoring in the most recent report (October) for the Consumer Price Index that showed year-over-year inflation growth of 7.7%, these projections would amount to a contraction in holiday sales for November and little to no growth in December [emphasis mine].”

Inflation has led to retailers boosting prices this year, straining consumers already dealing with negative real wages (wages adjusted for inflation). This has caused consumer spending to shift from discretionary purchases to essentials, leaving retailers with higher-than-desirable inventory levels. If that trend persists through the holidays, retailers may have to sell leftover inventory to discount retailers or flood clearance racks, potentially bad news for profit margins next year.

Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace weighed in on retail this week, writing:

“It's been a mixed bag out there in retail land…Reported quarterly figures are modestly ahead of some recently downward revised expectations, sending some of these stocks higher. But we would say that the innards of these reports are still somewhat disconcerting to us.”

Separately, they wrote:

“Despite the quarterly beat delivered by Best Buy, it still sees its fiscal 2023 North American comp sales down 10% year over year…Adding to that thought, Burlington's  (BURL)  guidance for the current quarter infers its comp sales falling 6%-9% vs. last year, while Abercrombie's  (ANF)  revenue guidance is down 2%-4% year over year…[We’re concerned] over bloated retail inventories heading into 2023. Case in point, inventories exiting October for Abercrombie were $742 million, up ~5% vs. the July quarter but 36% higher than last year.”

In short, many retailers, including Best Buy  (BBY) , Walmart  (WMT) , and Target  (TGT) , are warning of decelerating comparable year-over-year sales at existing stores even as inventory levels entering this holiday season are higher than a year ago.

Retail stocks to buy

Despite comp sales and inventory concerns, some individual retail stocks, including Best Buy and Walmart, have performed better than others, such as Target, this quarter, suggesting individual stock selection is increasingly important.

Real Money Pro’s Ed Ponsi points out in “Stock Shoppers, Here's the Best of the Retail Sector Right Now” that select retail stocks are back above their 200-day moving averages, providing technical support, including Best Buy, BJ Wholesale  (BJ) , and Walmart.

On Best Buy, he writes, "As a result of the solid earnings report, Best Buy popped 10% higher on nearly six times its normal volume (arrow). The dramatic increase in turnover is a sign that institutions are loading up on the stock. Best Buy also has formed a bullish double bottom pattern (black curved lines). That formation projects the stock to the $100 area, making that figure our target price for Best Buy."

Ponsi says BJ's is immune to the negative impact of a strong dollar because its stores are in the U.S., a fact that's helped it be a strong performer this year. He writes, "BJ's beat third-quarter earnings projections and raised its fiscal 2022 outlook. Although the stock fell slightly after the earnings report, BJ's remains firmly in a bullish trend."

Finally, he says about Walmart, "Walmart's 50-day (blue) and 200-day (red) moving averages formed a golden cross on Nov. 17. That bullish signal occurs when a stock's 50-day MA crosses above its rising 200-day MA...Walmart appears ready to make a run at its all-time high of $159. The retailer's emphasis on low prices will give it an advantage over its competitors in a potentially recessionary environment in 2023."

In addition to those stocks, many other retailers have recovered their 200-day moving average, including Victoria’s Secret  (VSCO) , Lululemon  (LULU) , Macy’s  (M) , Home Depot  (HD) , and Tractor Supply  (TSCO) .

The Smart Play

Data from industry watchers and trade groups will likely support or derail the recent rally in retail stocks. So far, early reports of holiday spending strength are encouraging, but investors may wind up disappointed if sales growth remains below inflation.

For instance, U.S. shoppers spent a record $9.12 billion online during Black Friday, according to Adobe Analytics. However, that was only up 2.3% from last year, significantly less than inflation. 

We'll get Cyber Monday sales data soon. If sales disappoint, it could make it harder to deliver on the National Retail Federation estimates for total holiday sales growth of up to 8%. Last year, November and December retail spending grew 13.5% year-over-year to $889.3 billion.

In addition to holiday sales updates from industry watchers, I’ll also be watching key earnings reports.

For example, Costco Wholesale  (COST)  reports its latest quarterly performance on December 8, and Dollar General  (DG)  reports on December 1. Both companies may offer insight into whether shoppers' are downshifting to lower-cost retailers, such as warehouse chains and dollar stores. Dollar Tree  (DLTR)  and BJ Wholesale already suggested that’s happening in their quarterly earnings calls.

I’m also curious to see what specialty retailers say about recent trends in their upcoming earnings calls, including Ulta Beauty  (ULTA)  on December 1 and Lululemon on December 8. Those reports should help us understand if consumers feel strained.

Separately, if we stick with Ponsi’s theme of stocks trading above their 200-day moving average, I’m watching Internet shopping plays Etsy  (ETSY)  and MercadoLibre  (MELI) , a South American e-commerce company. Each has already reported last quarter’s results, so I want to see if they can remain above the 200-DMA as holiday sales data rolls in.

I'm also watching Tractor Supply, given recent strong results from Deere  (DE)  and AGCO Corp  (AGCO)  bodes well for them. It’s also worth remembering that winter weather is tough on vehicles, supporting sales at auto supply stores. If cost-conscious consumers embrace a do-it-yourself mantra because of the economy this winter, then Autozone  (AZO)  and Genuine Parts Company  (GPC)  could build on recent gains. Each is among the few retailers already flirting with all-time highs.

Overall, there are likely to be winners and losers in the basket this season, so don't buy retail stocks blindly. If you're not interested in single-stock risk and favor ETFs, sitting on your hands waiting to see how retail sales data evolves could be best.

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