Taking Retail Off the Shelf

 | Feb 12, 2013 | 10:30 AM EST
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I recently pared down the allocation to retail stocks in my portfolio that are dependent on consumer spending. Most of this occurred naturally as I took profits on options initiated after the election selloff before their January expiration, or positions where I initiated covered call strategies that were called from my account. I have not redeployed these funds back into the consumer discretionary sector because I believe this area faces significant headwinds in the next few months that aren't fully factored into their valuation.

Obviously, one of the biggest negatives for consumer spending is the expiration of the payroll tax holiday that took effect January 1. This removes approximately $120 billion annually out of taxpayer pockets and should have a recognizable impact on consumer spending.

Gasoline prices began climbing steadily in January and have reached record levels for this time of year, which also erodes the money available for discretionary spending.

IRS tax refunds are running some $35 billion behind where they were at this time last year due to delays caused by the fiscal-cliff talks.

Finally, although job growth is muddling along at around 150,000 jobs a month, this is significantly below where it usually would be at this point in the business and economic cycle.

Given continuing uncertainty in Washington, possible sequester cuts, and the costs of the Affordable Care Act starting to be recognized by businesses, I do not see meaningful job growth or wage acceleration in the first half of 2013. I do not see job growth getting significantly worse, either, as I believe we will meander along at these levels for some time. The rebound in housing is the one big positive I see for consumer spending and that should continue.

I don't expect a major pullback in the consumer discretionary sector, however, this sector has been among the top performers in the market since the nadir in March 2009. Given these headwinds for consumer spending, the sector will underperform the overall market through at least the first half of 2013.

On the flip side, business balance sheets and the prospects for corporate spending are much more robust. Companies hold more cash on their balance sheets -- even after a special dividend onslaught at the end of 2012 -- than at any point in history. Spending on equipment and software jumped at a more than 12% annual rate in the fourth quarter, even as overall GDP was flat. Standard & Poor's predicts capital expenditures will increase approximately 10% in 2013, accelerating from 2012's level of around 7%.

On any dips in the market I will be moving my former retail money to sectors that serve businesses. Companies that benefit from fast-growing domestic energy production top my list: Flowserve (FLS), American Railcar Industries (ARII) and Chicago Bridge & Iron (CBI). They should continue to do well and outperform retail stocks.

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