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Retailers Valuations Cause Caution

Retailers played a strong role in upbeat fourth-quarter earnings as their strong results boosted S&P 500 Index earnings-per-share growth to 7.7% in the final weeks of the season. Supported by ongoing healthy consumer spending, strength in retailer operations bodes well for the U.S. economy and ultimately the stock market. These strong retailer results appear to be boosting investor confidence, especially because retail earnings growth now stands at 18% for the fourth quarter versus 12% at the start of February.

As corporations offer forward guidance for 2015, investors should remember that the fourth-quarter earnings season is now in the rear-view mirror. After all, we are already two months into the first quarter of 2015, and early 2015 economic data is off to a mixed start. The Chicago Purchasing Managers Index (PMI) was significantly below expectations and was the weakest data point for this series since July 2009. In addition, U.S. wage growth has remained flat, and the Institute for Supply Management manufacturing PMI has moderated recently and so has U.S. retail sales, though still healthy overall, suggesting that consumers may initially be saving their energy-related gains in disposable income.

With that in mind, it’s not a complete surprise that retailers’ upbeat quarterly performance has not flowed into 2015. The tone from retail management teams regarding outlooks has been rather downbeat, with many of them blaming investment spending, the West Coast port closures, and foreign exchange.

There’s a good chance that guidance is not a reflection of managements being too conservative either.  2014 results for a number of retailers that we analyzed were actually about in-line with initial guidance last year (detail in our March 5th note titled “The Retail Party Continues As Investors Shrug Off 2015 Guidance”).

That being said, the Retail Index has had an impressive run so far this year. It’s up 8.5% which compares to the 2% increase in the S&P 500. Clearly fourth quarter results have aided in this upside. However, the reduction in 2015 guidance combined with the index performance is leading to premium valuations for the group. The retail index currently trades at 25.2x on a forward price-to-earnings basis, a significant premium to its 15-year average of 19.7x.

In fact, the retail index traded above the historical average multiple for the majority of 2014 as investors bet on an improving consumer environment. Valuations like that suggests that investors and analysts still expect significant upside. Given the run-up in the retail index and its current valuations, we are taking a more cautious stance on the retail sector until valuations moderate.

See our note titled “The Retail Party Continues As Investors Shrug Off 2015 Guidance” published March 5th for more detailed thoughts on the retail sector and specific stock ideas.

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