R
The Retail Sector comprises business engaged in retailing merchandise, generally without transformation, and rendering services related to the sale of merchandise. Retailing is the final step in the distribution of goods to consumers. In addition to retailing merchandise, some types of retailers engage in the provision of after-sales services, such as repair and installation.
M
T
C YCLICAL ( CYCLE : GLOBAL ECONOMIC RECOVERY )
A number of analysts have revised GDP growth for 2011 upward near 3.5% from 2.8% since the announcement of the new Obama-GOP tax deal which, in addition to extending the Bush tax cuts for all income brackets, will allow businesses to expense 100% of the cost of assets put in use in
2011. The sluggish growth in mid-2010 that followed the 5% annualized growth rate in
FY09Q4 and 3.7% annualized growth rate in
FY10Q1 had elevated concerns of a double dip, though that seems less likely now with the tax deal in place.
That deal, announced in early December, extends unemployment benefits, cuts payroll taxes and adds some inducements for companies to buy new equipment, reinforcing growth fueled by consumer spending and business investment. As they strive for efficiency and cutting costs, companies are increasing their purchases of equipment—up 16.8% on an annualized basis in the third quarter. Expenditures on new plants or
I
F OOD AND B EVERAGE S TORES
Grocery Stores
Specialty Food Stores
Beer, Wine, and Liquor Stores
M ERCHANDISE S TORES
General Merchandise Stores
Department Stores
Other General Merchandise Stores
Miscellaneous Retail Stores
Florists
Office Supplies, Stationery, and Gift Stores
Used Merchandise Stores
Other Miscellaneous Store Retailers
Health and Personal Care Stores
Sporting Goods, Hobby, Book and Music Stores
Sporting Goods and Musical Instrument Stores
Book, Periodical, and Music Stores
Furniture and Home Furnishing Stores
Furniture Stores
Home Furnishings Stores
Electronics and Appliance Stores
M OTOR V EHICLES AND R ELATED
Automobile Dealers
Other Motor Vehicle Dealers
Auto Parts, Accessories, and Tire Stores
Gasoline Stations
B UILDING M ATERIAL , E QUIPMENT AND S UPPLIES D EALERS
Building Material and Supplies Dealers
Lawn and Garden Equipment and Supplies Stores
C LOTHING A CCESSORIES S TORES
Clothing Stores
Shoe Stores
Jewelry, Luggage, and Leather Goods Stores

other facilities, however, declined 5.7% (annualized) last quarter. Meanwhile, consumer spending rose at a 2.8% yearly pace, the highest since the end of 2006. Consumer spending is estimated to increase at a modest rate of about 2.5% next year, which implies positive earnings for retailers across the spectrum.
But despite the tax deal, growth expectations, and a strong holiday season for retailers, the realities of high unemployment and a still shaky housing market may continue to limit consumers’ ability and desire to buy in early 2011. Higher commodities and materials input prices may also bump up prices of some goods, further dampening demand. It seems reasonable for the sector as a whole to exhibit moderate growth in 2011, near 3%, but lower than 2010’s 3.5% growth rate.
C REDIT MARKETS AND I NTEREST R ATES
The Federal Reserve is expected to keep its benchmark short-term interest rate near zero through 2011.
With inflation at a low of around 1% and unemployment high at 9.8%, the central bank's greatest concern is warding off deflation and a recurrence of recession.
The goal of the Fed’s recent bond buying program, QE2, is to pump more dollars into the credit markets, giving the economy more time to strengthen via downward pressure on short-term rates. If short-term rates fall, that could induce consumer spending. Interestingly, the Fed’s second round of buying bonds point has coincided with a general rise in long-term interests. The 10-year Treasury’s yield has risen a half percentage point to 3.3% in just the past month, although changes in long-term rates are less indicative of changes in consumer spending.
By early next year, the FOMC will develop an "exit strategy" to reduce its Treasury holdings. That will be a form of gradual credit tightening, though the current prime rate of 3.25% can probably be expected through 2011.
I NFLATION
The Consumer Price Index (CPI) rose just 0.1% in November, leaving inflation over the past 12 months at
1.1%. By year-end, the 12-month inflation rate is expected to end up near 1.3%, a modest, unsubstantial increase.
Core inflation, which strips out energy and food prices, will rise even more slowly. The core CPI increased 0.1% in November and just 0.8% over the past 12 months.
But the economy is gradually absorbing the sum of the excess resources. The number of jobs in the private sector, for example, is increasing, albeit slowly, suggesting that inflation will increase mildly in the coming year and reinforces the unlikelihood of a deflationary spiral. As employment rises, we should expect consumers to spend more, especially if confidence improves among consumers about the general economic outlook.
E MPLOYMENT
Growth in employment rates is particularly important for retail sales. High unemployment over the past two years has dampened consumers’ abilities to spend. The tax package working its way through

Congress is sure to boost employment along with adding to GDP growth. Although productivity gains continue, it will be difficult for business to squeeze margins further, so employers will find it harder to delay hiring workers as economic conditions improve.
About 8.5 million jobs were lost in 2008 and 2009. Since the recovery began in June 2009, when GDP turned upward, only about 1 million jobs have been restored. Gains in employment have lagged—the economy lost an additional 1 million jobs in the first six months of the recovery. Moreover, economic growth, at 2.5% in the third quarter, is barely enough to meet job growth from newcomers to the labor force. Greater growth is needed, and that might be in the works. Optimistic estimates have the current
9.8% unemployment rate falling below 9% over the course of 2011, and that seems more realistic given the tax agreement. GDP growth will need to continue at 3.5% or more in 2012 to bring the rate significantly lower.
C ONSUMER CONFIDENCE
Confidence among U.S. consumers unexpectedly fell in December, restrained by concern that jobs will remain scarce in 2011.
The Conference Board’s confidence index unexpectedly fell to 52.5, lower than the most pessimistic forecast of economists. Another report showed home values dropped more than economists projected.
The loss of confidence is at odds with a report from the University of Michigan that showed sentiment improved to a six- month high in December, and with data showing holiday spending posted the biggest gain in five years. Federal Reserve policy makers this month said “depressed” housing and high unemployment remained constraints on consumer spending, supporting their plans to expand record monetary stimulus. Consumers remain very cautious and very nervous about where the labor market is headed.” The median forecast for confidence, based on a survey of 61 economists, projected confidence would increase to 56.3. The Conference Board revised the November figure to 54.3 from a previous estimate of 54.1. Projections ranged from 53 to 60.
Meanwhile, the S&P/Case-Shiller index of property values fell 0.8 percent in October from the same month in 2009. The decrease exceeded the 0.2 percent drop projected by the median forecast of economists surveyed. Property values are generally a contributing factor in households’ consumption decisions.
Despite the Conference Board’s data, 2010 holiday retail sales jumped 5.5 percent for the best performance since 2005, compared with a 4.1 percent gain during the 2009 holiday season.
O NLINE S HOPPING AND H OLIDAYS
U.S. consumers spent 5.5% more in the 2010 holiday season than they did a year earlier, bumping up apparel sales as well as high-end jewelry and luxury goods. Online sales were strong, up more than 15% for the period.
Perhaps the most exciting retail trend developing this holiday season is online and mobile shopping.
Retail outlets have rushed to offer mobile sales platforms.

Consumers, for their part, are increasingly using mobile devices as part of their shopping activities.
While 38.5% of consumers stated they don’t have a smartphone, over a quarter of consumers said they definitely planned to use their smartphone to research or make holiday purchases, according to the
National Retail Federation.
I NPUT P RICES
NYC C OTTON CV 1
Rising cotton prices will impose significant costs on the retail sector—especially apparel stores and department stores (ARO, AEO, ANF, M, JNF)—going into 2011. The question remains as to whether or not that cost will be suffered by suppliers, retail outlets, or consumers. Given factors limiting consumers’ income such as high unemployment and lower home values, it is unlikely that retailers will be able to pass those costs onto consumers and it is reasonable to expect lower operating margins next year. This trend is critical and suggests that we should be cautious regarding investments in apparel-centric companies until cotton prices stabilize.

R
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M
S&P R ETAIL (^RLX) VS .
S&P 500 (^GSPC)
------- = S&P Retail Index (^RLX)
------ = S&P 500 (^GSPC)
After two years of the retail sector posting underwhelming end-of-year gains relative to the market (in
2007 and 2008) and last year’s sluggish rates, retail sales accelerated dramatically at the end of 2010. It remains uncertain whether or not those gains will carry over into 2011. Sustained improvement in retail sales will primarily depend on improvement in the labor market. Retail sales in November were up 6.8 percent compared with the same month last year, with apparel stores leading the sector. Although retailers typically do well during the holidays, the extent to which U.S. consumers hit the stores relative to prior seasons may hint at consumers expectations of rising income in the future.
S&P R ETAIL (^RLX) VS .
E URO /USD E XCHANGE R ATE (EURO/USD = X)
------- = S&P Retail Index (^RLX)
------ = EURO/USD
EURO/USD ForEx market developments appear to have had negligible impact on retail sales. The fall in U.S. retail stocks during 2008 coincided with a modest depreciation of the dollar, contrary to expectations, though the trend corrected itself throughout 2009 with U.S. retail sales touching a three-year high at the worst of the Greek

sovereign debt crisis in early 2010. In the second half of 2010, U.S. retail stocks resurged amidst relative ForEx volatility surrounding QE2 and concerns about Irish banks. The retail fervor of the 2010 holiday season was, in some part, due to cross-border online sales between European consumers and U.S. high-end retailers for luxury goods, with companies like Tiffany & Co. (TIF) showing remarkable strength. U.S. retail stocks may have been assisted by moderate appreciation in the Yuan in the second half of 2010, although the trend can only account for a fraction of U.S. cross-border retail sales.
S&P R ETAIL (^RLX) VS .
CBOE I NTEREST R ATE 10-Y EAR T REASURY N OTE (^TNX)
------- = S&P Retail Index (^RLX)
------ = 10-Year Treasury (^TNX)
The rise in both U.S. retail stocks at interest-based T-note indices over the past quarter illustrates how investors have reentered equities markets after a disheartening mid-2010. QE2 could hold down short-term interest rates, but that would positively affect credit-based consumption and retail stocks through stronger earnings. In either case—whether through stronger 2011 earnings are through the flight of investors away from safe UST notes and back into equities—the environment for retail equities going into 2011, insofar as its relationship to interest rates is concerned, appears favorable.

H
P
S
F OOD AND B EVERAGE S TORES
Overall, the adult beverage makers saw modest improvements in sales throughout 2010. The effects of the global credit crisis seemed to undermine the belief in the inelasticity of demand for alcohol. Guest traffic at bars and restaurants was significantly down, and this caused a shift in consumption to the lower-profit, at-home channel. High unemployment and fragile spending caused many consumers to trade down away from premium and super-premium spirits. However, with the economy showing signs of a rebound, distillers are seeing growth across the board.
M ERCHANDISE S TORES
Spending on merchandise should favor high-end and luxury goods retailers like Tiffany (TIF) and Nieman Marcus
(NMG) above discount retailers like Wal-Mart (WMT) and Target (TGT).
Notice the difference with the last recovery, when spending initially grew faster at the discount retailers:
Real per capita spending on durable and nondurable goods is increasing, although real per capita spending on services is still lagging. Sales at upscale retailers are bouncing back faster than in the previous recovery, while sales at Target and Wal-Mart are expected to grow less than one percent in 2010.
M OTOR V EHICLES AND R ELATED
For the automotive replacement parts industry and parts retailers the road has been much less bumpy than most industries over the last couple of years. As consumers limited expenditures to necessary items, new car purchased declined and dealerships suffered as expected; meanwhile, the average age of vehicles on the road has continued to increase, as has the mileage driven. In addition, the automakers' troubles resulted in thousand of dealership closings that has sent many drivers in need of repairs to independent garage services provided by auto parts retailers.
These favorable trends have helped the replacement parts sector become one of the best performing throughout the recession and in the slow recovery currently taking hold. The recent continuation of these trends was confirmed last week by the country's largest aftermarket auto parts retailer, AutoZone (NYSE: AZO). Like its

top competitors O’Reilly Auto Parts (Nasdaq: ORLY) and Advanced Auto Parts (NYSE: AAP), AutoZone easily topped analyst estimates in its most recent quarter. In fact, the company's first quarter was the eighth consecutive quarter in which earnings per share grew by more than 20%, and the 17th straight quarter that saw a greater-than-10% increase in EPS.
Another factor that has benefited the aftermarket parts sector has been the weather. Major auto parts dealers are all acknowledging that the extreme weather of late 2010 has helped sales.
C LOTHING A CCESSORIES S TORES
Based on better-than-expected 2010 holiday retail sales, specialty apparel retailers are poised for strength heading into the first earnings season of 2011. Despite concerns about discretionary spending amid elevated unemployment rates in the United States and economic uncertainty in a number of overseas markets, many analysts believe that specialty apparel retailers are expecting continued sales and earnings momentum in early
2011.
There are two trends worth noting in relation to specialty apparel retailers in 2011. First, international and ecommerce growth. A number of big names like Wal-Mart (WMT) and Sears Holdings (SHLD) have opened thirdparty platforms and mature retailers with strong brand names have been expanding aggressively into Asia and
Europe, especially China. Inditex, the largest apparel company, is currently channeling more than 50% of its new store investments into the region to capitalize on the growing middle class population. The population of individuals earning between $15,000 and $20,000 annually in China has grown by more than 400% (22 million people in raw numbers) over the past five years, and that number is expected to more than triple to 81 million people by 2015.
Second, rising input costs. Over the past year, distribution expenses and commodity prices have increased meaningfully, as manufacturing demand outpaced supply following a modest recovery in consumer spending and as retailers restock inventory. According to the Journal of Commerce, the price of shipping a 40-foot dry container from China to the U.S. averaged $2,200 in 2010, up 90% from $1,100 in the prior year. Additionally, the price of cotton (which is a primary raw material for apparel manufacturing) increased approximately 30%-
50% earlier this year to $0.80-$0.90 per pound, as demand from apparel manufacturers picked up. The supply/demand imbalance was further exacerbated by bad weather in the world's largest cotton producers, including China, India, and Pakistan (which accounts for 30%, 20% and 8% of global production, respectively) in recent months, which pushed cotton prices up another 70% to $1.55 per pound by November 2010. This is an extremely dangerous trend for apparel and specialty retailers that will place downward pressure on dividends growth and ward of investors in early 2011.

F
R
The retail sector as a whole looks poised for moderate to strong growth through the beginning of 2011, accelerating through the rest of the year as unemployment data improve and macroeconomic conditions stabilize in Europe. My favorite companies right now are those with broad exposure to both high-end and discount consumers, online (and/or mobile) sales platforms, and are positively correlated with market indices as a whole. The following table lists four companies that meet these criteria and look particularly strong heading into early 2011, Amazon, Nordstrom, Inc., Macy’s, and Home Depot. I have intentionally avoided specialty apparel and footwear companies because of rising input costs (from rising commodity prices) that will inevitably pinch margins and are likely to begin affecting those companies in the first quarter of 2011.
Company
Status
Amazon
Ticker
Forward
P/E
Avg. EPS est.
AMZN
52.36
3.49
Fair Value 182.7364
Current
Price
182.75
30 Dec. 2010
Nordstrom,
Inc.
JWN
14.05
3.02
42.431
42.44
Macy's
M
12.11
2.27
27.4897
25.24
Home
Depot
HD
15.56
2.24
34.8544
34.86
Fair Value Fair Value Undervalued Fair Value
Mean
Target
Beta
Div & Yield
5-year PEG
(expected)
179
1.1
N/A
2.71
44.71
1.85
1.90%
1.45
29.4
1.95
0.80%
1.56
36.5
0.77
2.70%
1.28
M ERRILL L YNCH & C O ., I NC R ETAIL I NDEX (RTH), T OP T EN H OLDINGS (12/28/2010)
Company
Wal-Mart Stores, Inc.
Common St
Home Depot, Inc. (The)
Common S
Symbol
WMT
HD
Industry
Discount, Variety
Stores
Home Improvement
Stores
Market
Cap
192.63B
57.18B
Recommendation
Buy
Strong Buy

Drug Stores
Beverages-
Brewers
Beverages-Soft
Drinks
Beverages-
Wineries &
Distillers
Department
Stores
Office Supplies
Amazon.com, Inc.
Target Corporation
Common Stock
Walgreen Company
Common Stock
Lowe’s Companies,
Inc. Common S
Costco Wholesale
Corporation
TJX Companies, Inc.
(The) Commo
CVS Caremark
Corporation Common
Best Buy Co., Inc.
Common Stock
K EY S TATISTICS BY S ELECTED I NDUSTRY
AMZN
TGT
WAG
LOW
COST
TJX
CVS
BBY
Industry
Grocery Stores
Market
Cap
1,410B
85B
4377B
263B
168B
349B
1B
As of 28 December 2010
P/E P/B
Net Profit
Margin
NM 3.8 -1.10%
P/FCF
41.5
ROE
0%
17.8 7.6 2.40%
24.7 -7.7
18.8 12.2 11.70%
11.8 -8.2
16.8 2.6
15.3 -6
Catalog & Mail Order
House
Discount, Variety
Stores
Drug Stores
Home Improvement
Stores
Discount, Variety
Stores
Department Stores
Drug Stores
Electronics Stores
15.30%
14.20%
2.70%
2.20%
25.5
38
46.2
25.6
-27.5
-22.9
82.30B
42.41B
36.71
34.54B
31.56B
17.66B
47.42B
13.62B
9%
17%
23%
27%
11%
Strong Buy
55
Neutral
Sell
Neutral
Buy
Neutral
Strong Buy
Strong Sell
Total
Debt/Equity
69.1
25.2
44.7
206.6
86.1
17.40% 28.4
Dividend
Yield
1.70%
1.40%
0.90%
2.50%
3.60%
1.30%
2.10%

Health and
Personal Care
Stores
Sporting Goods and Musical
Instrument
Stores
Music & Video
Stores
3,001B
2B
9B
Home Furnishings
Stores
18B
Appliances 13B
Electronics Stores 20B
Automobile
Dealers
Recreational
Vehicles
22B
14B
Auto Parts,
Accessories, and
Tire Stores
Building
Materials
Wholesale
Apparel Stores
Jewelry Stores
763B
1B
121B
163B
Specialty Retail 349B
Discount Variety
Stores
362B
15.9 11.3 12.90%
32.6 1.9 2.20%
59 19.9 3.70%
20.6 2.8
20.7 5.4
5.60%
17.1 23.1 2.70%
12.3 4.4 3.10%
1.60%
57.4 3.5 2.00%
26.5 5.3 2.70%
25 7.9 1.20%
15.5 3.5 5.40%
25 2.2 4%
21.6 8.6
14.2 3.6
3.00%
3.50%
184.2 24.30% 29.5
26.3 5.30% 79.7
1159.7 27.00% 122.2
54.6 13.60% 3
-66.9 9.80% 74.7
-40.3 19.00% 28.6
43.9 8.90% 172.6
12.1 5.40% 219.9
36.6 10.40% 125.9
-208.2 5.80% 205.4
532.6 17.70% 566.2
-50 8.70% 41.1
149.4 12.90% 78.4
130.7 21.10% 82.8
2.90%
1.60%
0.00%
2%
1.00%
1.80%
2.00%
0.00%
1.20%
1.60%
1.70%
0.50%
1.20%
1.20%