The rising cost of Chinese goods could hurt retail stocks

I’ve been in or around trading, traders, brokers and analysts since 1985, and I have never seen the people inside the industry so tired, frustrated and gloomy.

Phone call after phone call, visit after visit, dinner after dinner, I hear the same thing: gloom over the U.S. economy, gloom about the debt and deficits, and gloom about the disappearance of so many individual investors. And that’s on top of the fatigue about the day-to-day ups and downs in the market unrelated to fundamentals and driven by light trading volume.

They all say with a sigh, “And it’s still only September.”

That’s the first half of any conversation with industry professionals. The second half is about what is going to happen during the remainder of the year. Analysts and traders are conflicted because the stock market is trading as if profits will be OK in Q3 and Q4 — and even better next year — while the bond market says we are probably already in the second part of the double-dip recession. These are the same people who make most of their living with equities and “know” the bond market is rarely if ever wrong in the long run.

The bulls respond by saying liquidity is at levels never before seen in history: Zero percent interest rates, an expanded Fed balance sheet and the expectation that quantitative easing (meaning more expansion of the Fed balance sheet) is on the way.

The bears’ answer is just as simple: Equity markets follow corporate profits and they are headed sideways and then will turn down.

What will this mean for us?

First, expectations for corporate profit growth in 2011 are way too high at 14.7% for the S&P 500 based on a consensus estimate. The estimate for 2011 was 25% in January, then 20% in April, and the spiraling down of expectations explains a good deal about the recent market behavior.

Second, the double dip is going to be harsh. Washing! ton has no ability to soften the blow and corporate profits must follow. This will develop over many weeks. I don’t think there will be a crash, although the longer the market defies fundamentals the more some sort of crash becomes a possibility.

Unlike the 2008 Lehman debacle, this drop will be manageable for professionals and active investors. And the long-anticipated slide, once over, will push people back into a process of looking at the performance of individual companies and stocks, not just the indices. That will create new opportunities for the short positions that slide faster than the market, and long positions that defy the market. (See 11 Stocks Headed Up Even If the Market Isn’t.)

RetailSector: Empty Stores, Rising Costs

I continued my hands-on investigation of retailers this past week at some of the most frequented malls in the Washington, D.C., area. The bottom line is that I believe the back-to-school season will prove to be a serious bust.

The Street has yet to catch up. Retail stocks, although down 18% since April, are up 11% in 2010, because the retailers increased profits by squeezing costs. But the situation is about to reverse itself thanks to China.

China’s appreciating currency, and rising wages and shipping costs from the Far East are going to hit the cost of goods for many retailers. According to a survey by Credit Suisse, half of the companies responding said they see Chinese goods rising in cost by 6% to 10% during the next four quarters. And 93% of respondents said they will take a profit margin hit because they are unable or unwilling to pass it on to their customers.

Who will get whacked the most? Chinese products are responsible for 20%-40% of the cost of goods at many big-name retailers — 15% for Best Buy Co., Inc. (NYSE: BBY), 20% at Macy’s, Inc. (NYSE: M), 20% at Target Corporation (NYSE: TGT) and a whopping 40% at Dollar Tree, Inc. (NASDAQ: DL! TR).

It gets even worse for apparel makers. Credit Suisse puts the cost of goods from China at 55% for Carter’s, Inc. (NYSE: CRI), 50% for Maidenform Brands, Inc. (NYSE: MFB), 35% for Foot Locker, Inc. (NYSE: FL) and 30% for Liz Claiborne, Inc. (NYSE: LIZ).

The bottom line is that most retailers have no top-line growth and have seen their stocks appreciate due to increased profit margins. The more they are exposed to China the more these profits will decline. So we’ll keep an eye on these as things in China develop.

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