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Derek DeCloet

U.S. retailers may be hot stocks now, but be wary of a big chill

Globe and Mail Update

'I'm tapped out, Marv. American Express got a hit man lookin' for me." So said Bud Fox, the character played by Charlie Sheen in the movie Wall Street.

Fox, a stockbroker who falls under the influence of the infamous Gordon Gekko, goes on to have an ugly confrontation with his father, a blue-collar type who can't understand his son's fast-money values. In real life, the Street's behaviour can be just as confounding to the lunch-pail set.

Consider this week: The U.S. unemployment rate fell to a 4½-year low in January, and the stock market dropped in response. Good news equals bad news.

TV news anchors will explain it to the masses with four words -- "inflation" and "higher interest rates" -- but the truth is a bit more complicated. If higher rates take money out of people's wallets, after all, higher wages ought to put some back in. Why be gloomy, Wall Street? Because, frankly, it doesn't matter much if workers are getting slightly bigger raises this year. Paycheques still aren't getting much fatter, in real, inflation-adjusted terms, and consumers are tapped out, Marv. If American Express doesn't have a hit man lookin' for people, it's only because that would be bad for business (not to mention illegal).

That Americans are racking up more debt, and saving nothing, is not a new story. Here's what is: For the first time this decade, their spending has begun to far outpace any growth in their disposable income. Myles Zyblock, who toils for RBC Dominion Securities as a strategist, has a word for this: "unsustainable."

The dismal state of the U.S. consumer's balance sheet has naturally led to a Gekko-ish search for a way to profit from others' misery. One popular idea among hedge funds has been to short home-building stocks, on the theory that no market is more sensitive to rates and consumer weakness than an overheated real estate market. The numbers seem to suggest this idea is a can't-miss.

The inventory of unsold homes in the U.S. has "exploded," says Mr. Zyblock, and is now at levels far higher than during the economic shocks of the 1970s.

The problem is that much of this has already been discounted into home builders' share prices. To take one example, Toll Brothers, a luxury home builder with a long and consistent record of rising profits, has been so battered since last summer that it now sells for a dirt-cheap seven times earnings. There's only so much lower it can go.

But this week's market activity suggests another avenue for those who believe the U.S. is headed for a wave of bankruptcies and who wouldn't mind making a ghoulish buck out of it. American retailers have, for the most part, prospered from the sloppy financial habits of their customers. If even-higher rates are coming, that cannot last.

Think back to investment themes you've read about over the past few years, and chances are one stands out above the rest. China's emergence as a modern economy is one of the great economic events of the past 25 years, not to mention the source of a commodities rally unlike any since the 1970s. So which do you think has been a better investment: the basic-materials companies whose products (aluminum, steel, copper) are necessary for a construction boom in the world's most populous country? Or U.S. retailers, whose business is to suck more dimes out of a consumer who doesn't have many to spare?

The answer is the shopkeepers, as represented by the S&P 500 retailing index. That may last a bit longer, until it dawns on people that home values can go down as well as up. The evidence from Britain says a big correction isn't necessary; all it takes is for the real estate market to cool down and consumers soon begin to stay away from the malls. It's the wealth effect in reverse.

We note that despite all the proof this week that cash registers are still overheating, U.S. retail stocks have done almost nothing this year. Yet expectations remain high; the average multiple of the biggest American chains is still 22 times earnings. Investors have short memories, and the stores have been so busy for so long that it's easy to forget what happens to retail stocks when the customers go away -- they get shredded. This may be the most dangerous part of the stock market in 2006.

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