Tickers in this Article: JWN, ANF, TLB, PSUN, SHLD, URBN
A big pet peeve for many analysts is the market's tendency to overreact. Especially when it comes to the recent surge in retail stock prices, as investors are overly optimistic about a potential recovery in the consumer sector. (Find out how a cat and a ladybug prove markets are both random and efficient, read Seeing The Market Through The Trees.)
The ytd performance of several major retailers:
Company Year to Date Return Trailing P/E
Pacific Sunwear (Nasdaq:PSUN) 170% N/A
Abercrombie & Fitch (NYSE:ANF) 42.9% 50% 20
Talbots (NYSE:TLB) 150% N/A
Sears (Nasdaq:SHLD) 95% 69
Nordstrom (NYSE:JWN) 110% 17
Urban Outfitters (Nasdaq:URBN) 85% 26
As of mid-day Aug 14, 2009

Nonsensical Returns
Even for retailers like Nordstorm and Urban Outfitters - companies that both boast strong business models and robust underlying operational structures - these returns are absolutely unjustifiable. What's even worse is that the rest of this list consists of retailers plagued with firm-specific problems. Both Pacific Sunwear and Talbots are drowning in red ink, yet both stocks more than doubled in price since the beginning of the year. (Learn more about this sector in Analyzing Retail Stocks and Using Consumer Spending As A Market Indicator.)

With the economy finally showing signs of stabilization and consumer spending levels bottoming, the market is pricing retailers in anticipation of a near-term full recovery. Many analysts argue that the retailers are cheap because they still trade far below their 2007 values.

The problem is, the sector should be selling at a discount because it's going to be a very long time before consumer spending reaches the levels it did at the height of the credit bubble.

A Pseudo Recovery
Even if spending is revived in the near term, it will be artificial growth. That's because the government is trying to stimulate spending by keeping rates close to zero. In reality, cheap credit is the last thing consumers need right now. A debt fueled spending spree may send the economy into a temporary recovery mode, but will ultimately land us right back where we were a few months ago - in a massive recession.

It's possible that consumers will dodge the credit trap the Fed is dangling in front of them, as many Americans learned a hard lesson about leverage over the last two years. But retailers still face major challenges beyond the macro environment.

In order to mask revenue declines as consumer spending plummeted, retailers took drastic measure to move inventory off shelves. Extreme promotional activity has likely conditioned shoppers to avoid paying full price. Consumers have now become so accustom to finding bargains, and it's doubtful that retailers will successfully regain the brand power they once had to charge premium prices.

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A Melodramatic Market
You wouldn't know it by looking at retail stock movement right now, but retailers have a rough road ahead in terms of resuming to business as usual. Just as many retailers were oversold last year, as the market dramatized the downturn in consumer spending, the current recent retail rally far exaggerates the sector's near term potential.

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