Call #1: Maintain Underweight US Retailers
In a recent Behind the Numbers post, we noted that last Friday’s US employment report is yet another sign of a slow recovery and we hinted at what this means for US retailers.
This week, our first call focuses in more detail on the investment implications of a slow recovery for the US retail sector. We first highlighted our negative view of the US retail sector last December and then reiterated it in March and last month. We are now reiterating our view again as we continue to believe the sector still appears overvalued.
The ongoing challenges facing the consumer – a weak labor market, anemic wage growth, too much debt and a stagnant housing market – have been well documented. To our thinking, these issues are not likely to be resolved in the near-term. Yet despite the long litany of problems, investors continue to favor US retailers. We believe this enduring faith in the willingness and ability of the US consumer to spend is misplaced.
Take how much consumers are actually spending, for instance. Last quarter, inflation adjusted personal consumption in the US grew by 2.2%, well below the long-term trend. Unfortunately, this number was not a fluke but is indicative of the pace of spending that we’ve seen over the past couple of years. Given all the headwinds facing the consumer, most importantly a weak labor market, we don’t expect spending to pick up materially over the next six to 12 months and 2% is probably a reasonable proxy for personal consumption growth over the next 12 to18 months.
Yet despite the below trend growth in spending, retail stocks continue to trade at a premium. Large-cap US retailers are currently trading at more than 19x trailing earnings, nearly a 30% premium to the broader market. What is even more surprising is that this premium exists despite persistent weakness in job creation.
Not surprisingly, retail stock valuations have historically moved in-line with labor market conditions. When job growth is strong and wages are rising, investors tend to assign a higher premium to retail stocks. Conversely, during periods of weak job growth, investors are generally less willing to pay up for stocks that are ultimately dependent on the health and spending power of the US consumer.
Today, despite the fact that non-farm payrolls are growing at around 0.8% a year, less than half their historical growth rate, the market is assigning one of the largest premiums to retailers that we’ve seen in the past decade. Based on the current state of the labor market, retailers appear 10% to 15% too expensive relative to the broader market.
This disconnect between the labor market and retail valuations can probably be explained by investors still placing too much faith in the type of consumer resilience demonstrated during the last decade. Between 2000 and 2006 personal consumption managed to grow at a healthy rate, despite a recession and the bursting of the equity bubble. Much of that resilience can be attributed to a surging housing market and cheap credit. Today, the housing market remains stuck in the doldrums, credit is still cheap but no longer readily available and government transfer payments are decelerating. In short, it is not clear what will bail out the consumer this time around.
We believe that the recent weakness in consumption is likely to persist for the remainder of 2011 and into 2012. At some point, the valuations of retail stocks should reflect this. As such, we continue to advocate an underweight view of US retailers as well as of international companies leveraged to US consumption.