A Glut in Specialty Retailers

The Daily Reckoning PRESENTS: It’s the marginal consumer that keeps dozens of specialty retailers afloat. Miss one fashion trend, or allow the competition to poach your customers, and it could mean lights out in a hurry. Dan Amoss explains…


Year after year, the American consumer lives and breathes the quote originally attributed to Mark Twain: “The rumors of my death have been greatly exaggerated.” Your local landfill is now making compost of predictions warning about the imminent demise of the American consumer. These predictions will likely prove correct one day, but the timing is very difficult to nail down.

These predictions of consumer retrenchment have not appreciated or fully respected a key tenet of human nature: When given the option to consume without producing (via credit cards), most people will choose “yes,” and most people are reactive adjusters, rather than proactive planners. Instead of keeping in mind the odds of a job loss or a slump in the housing market, most consumers wait until they run into the proverbial budgetary brick wall before they adjust spending habits.

Though it’s generally a bad idea to speculate on the possibility that consumers will reverse their habits overnight, drastically cutting back on spending, the odds shift in your favor if you selectively bet against the consumer. Referring to short sale candidates, J. Carlo Cannell of Cannell Capital asked the audience at this year’s Value Investing Congress West, “Why should I go hunting in the rainforest for a puma when I can shoot a sick pigeon at the side of the road?”

There are many “sick pigeons” at the side of the road, waiting to be put out of their misery. They routinely consume far more capital than they will ever return to shareholders, and should be liquidated in order to allow capital to be diverted to more productive uses.

Using the past three years of hindsight, this means selling short Pier 1 rather than J.C. Penney, Krispy Kreme rather than Panera Bread, or Gateway rather than Apple. Whether it’s due to obsolescence, fads, end market saturation, dumb acquisitions, or misguided corporate strategy, the reasons for 50-99% of crashes in a stock are numerous. So when the market gives you an opportunity to sell short a stock with several of the aforementioned characteristics (and is quite expensive relative to its earnings power), it’s an opportunity you should take advantage of.

Specialty retailing is a market segment littered with “sick pigeon” short sale candidates. While a recession may signify little more than an inventory adjustment and a 30% stock correction for the Wal-Marts of the world, it represents a death knell for some specialty retailers counting on a critical mass of consumers continuing to overspend on very discretionary items.

While it’s not reasonable to assume that consumers will change their habits overnight, it’s reasonable to assume that most are a) fickle and b) too addicted to the “doorbuster” type of sales that are becoming mandatory in order to draw foot traffic. It’s the marginal consumer that keeps dozens of specialty retailers afloat. Miss one fashion trend, or allow the competition to poach your customers, and it could mean lights out in a hurry.

Retailers usually declare bankruptcy when traffic and cash flow slows to the point where they can no longer repay suppliers for inventory on loan, make payments on their revolving debt, and make the contractual lease payments that they owe to their REIT landlords.

How did specialty retailing reach this point of saturation? The top reason is the incredibly easy credit conditions of the past generation. Consumers have been given every opportunity to overspend, and private entrepreneurs have been more than willing to oblige.

Craft and fabric retailing has leapfrogged from cottage industry to logistically complex nationwide empires – all with the intent of fulfilling demand for an eye-opening array of slow-turning merchandise. Lenders with more focus on fees than on risk have fallen over themselves to finance store openings and inventory builds, much of which will be liquidated at an economic, if not accounting, loss.

Now, the tide should reverse, or at least stagnate, favoring the retailers with the strongest balance sheets, best management teams, and most loyal customer bases.

Fiat monetary systems without the checks and balances of the gold standard allow credit creation to run out of control. It has greatly diminished lenders’ need to accurately price risk and ration credit. Therefore, a great number of loans made to retailers over the past few years were made with poor assumptions about sustainability of the underlying business.

In the latest issue of The Richebächer Letter, Dr. Kurt Richebächer writes:

“It is one of the key postulates of Austrian theory that the most harmful effects of credit inflation are not in the price indexes, but in the misdirection of resources that it causes. For American economists, lacking any understanding of this part of the inflationary process, all these structural distortions are irrelevant.

To be sure, over time, they impinge on economic growth in various ways. The lowest interest rates in half a century and the biggest fiscal stimulus in U.S. history during 2002-2004 have given the economy a one-off boost, but the resulting recovery plainly lacks any self-sustaining and self-reinforcing traction.”

The housing boom that ended last year was fueled by inflation. An “asset-based” economy is simply not sustainable over the long run. Since the housing boom promoted a “one-off spending boost,” the profits of retailers that benefited the most from this boost should be viewed as artificially inflated.


Dan Amoss, CFA
for The Daily Reckoning
December 28, 2006

P.S. This month, I have a short sale recommendation for my Strategic Investment readers. It’s a financially weak retailer in the highly discretionary business of selling fabrics and crafts. This specialty retailer is attempting to dodge cutthroat, world-class competitors in a razor-thin margin business – all while trying to make enough profit to cover overhead and debt payments.

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

It is like Siberia here…or at least as we imagine Siberia; we’ve never been there. This morning, everything – trees, grass, houses – are all covered in white crystal – not snow, but thick frost. More below…

But the stock market is hot. The Dow hit a new record yesterday. With only two days left to go in the year, traders and investors are getting in position…adding the shares they want to own for 2007…snorting with confidence…chaffing at the bit to begin another run around the track.

The IMF says investors are ‘too complacent.’ We agree. That’s why we have issued our Crash Warning. Not that we know something is going to go wrong soon…it’s just that if something were to go wrong, a lot of people would be greatly inconvenienced. The are so many optimists…betting so heavily that things will continue as they have been…that the odds favor the naysayer, the contrarian, the pessismist, the crank doom and gloomer.

The typical investor owns stocks that are too expensive…compared to the dividend yield he receives. And the typical householder owes too much money to too many people – especially the people who’ve lent him money on his house. His house, too, is over-priced for what it is; if he had to rent it out, he’d never get enough money to cover his costs and give him a fair return on his capital.

But the news dribbles in day by day…and so far, the news is not bad. New house sales are greater than expected, according to the most recent report. So, investors and economists are beginning to think – as Alan Greenspan has proclaimed – that the worst of the housing slump is behind us.

‘The worst is behind us’ is a remarkably upbeat assessment. We turn our heads and we don’t see anything bad back there. Stocks have been hitting new highs…consumers are still spending…and even house prices are, officially, holding at their highs or even creeping up a little. If that’s the worst there is – well, bring it on!

Oops…there, we’ve said it, haven’t we? Like George W. Bush, we’ve tempted the gods. Now, they will want to teach us a lesson; that there are some times when you don’t ‘muddle through.’ Most of the time, trends in motion tend to stay in motion. But not all the time. Sometimes, they stop and a new, different trend begins. That is when the gods ‘bring it on’ and give it to us good and hard. And that is when you discover that all those things that you thought were so smart, were too clever by half.

Who are the smartest people around today? Derivatives traders and hedge fund managers, of course. They’re the ones earning millions of dollars each year. They are building huge houses in the Hamptons and bidding up prices of Picassos.

What do they do to earn so much money? What do they produce? What do they make that so improves others’ lives that they deserve to get filthy rich? Don’t bother to ask, dear reader. You won’t get a clear answer. Instead, you will be told that they ‘allocate capital’ or ‘arbitrage discrepancies’ in the modern capitalist system. What they are really doing, of course, is the same thing that people do in Las Vegas – they are gambling.

And as long as the pot is getting bigger…they will probably do all right.

John Succo, a hedge fund manager, addressed a letter to the New York Times, explaining:

“The Federal Reserve creates credit through its open market operations like REPOS and coupon passes. If the Fed wants to inject liquidity (credit) into the system, they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air (this expands their balance sheet). The dealer then passes this credit on to “the market” by making loans to mortgage companies or margin accounts or whatever. Because each layer of lender is only required to keep marginal capital on hand, a $1 billion REPO done by the Fed eventually creates as much as $100 billion in new credit to the consumer.

“That credit creates the liquidity for additional consumption in the U.S., but these days we are buying our stuff from China (other countries too but we will just say China to make it easy). When a Chinese company receives dollars in trade, this normally would drive up U.S. interest rates: the company goes to the central bank of China to exchange Yuan for dollars; the central bank of China would normally sell those dollars into the currency market for Yuan thus driving up U.S. interest rates. But in our world of today these dollars are being sterilized: the central bank of China prints the Yuan to give to the company and takes the dollars and buys U.S. securities.

“It is not the excess savings of Chinese investors that are buying U.S. securities. It is central banks creating credit themselves to buy those securities. The tick data that measure foreign inflows of money does not distinguish between private investors and central banks going through brokers to buy U.S. securities. We believe that as much as 90% of foreign money buying U.S. securities (not just Treasury bonds, but corporate bonds, mortgages, and yes, stocks) is not private investment, but central banks.

“In order for other central banks like China’s to print the Yuan necessary, they too must create credit. Public debt in Asian countries is expanding as a result and creating worries: this is why Thailand came out essentially raising margin requirements to reduce speculation that is occurring as a result. Notice how they were quickly slapped down by their trading partners who do not want to rock the boat at this time.

“This situation is very unstable in the long run. The Federal Reserves’ balance sheet this year alone has expanded by $30 billion in this way and created $3.5 trillion of new credit in the U.S. Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).

“My hedge fund’s position is the opposite of the carry trade you mention. There is coming (timing is unclear where it may be tomorrow or may be years away) a massive correction in debt and derivatives whose magnitude is only growing with time.”

It could be tomorrow. It could be years away. But it will be eventually. And the more complacent people are, the more they will suffer when it does come. But we will have more specific guesses for the New Year soon…

More news:

And more thoughts:

*** It looks like oil will end the year at about $60…the dollar at $1.31 to the euro…and gold at $630.

*** Last night, at a cocktail reception, we met a man who has started up a WIMAX business, with a license for half of France:

“WIMAX is just the next generation in broadband communications,” he explained. “We use old radio towers and transmit a signal. It can be used to connect to the Internet, of course, but also a lot of other things. You can use it to make phone calls. Or to connect your GPS system. Or to turn to monitor your home heating system. We believe it will replace all these fixed wire systems as well as the public WIFI systems. The trouble with WIFI is that you can’t control who uses it or what they do with it. And it is only in one direction. WIMAX is different. Each customer has an account; you can control the users. You can control how they use it. And it almost infinitely versatile. This is going to be where the money is made in communications technology in the years ahead.”

*** It is colder than we are used to. France has a mild climate, generally neither as cold nor as hot as most places in America. And here, we have a big stone house, without insulation. We cannot hope to heat the whole thing, so we concentrate in a few rooms – where the radiators are turned up and fires burn in the fireplaces.

“I was cold all day long,” said Elizabeth after dinner last night. “Maybe we should go back to Paris.”

“I don’t know how your grandparents did it,” she continued after a few minutes. “They lived in a house in Maryland without electricity or central heating. It was colder there than it is here. And they had nothing to look forward too. They didn’t say to themselves… ‘Oh, next year we’ll put in central heating.’ Instead, they just lived with those wood stoves…and they must have been very cold. And they couldn’t decamp to the city…or move to Florida. After your grandfather was wiped out in the Depression, I guess they had no choice.”

Why bother to make money, dear reader? Here we have the answer: so you can get warm.

But wait…before the days of central heating, everyone must have heated with wood, coal and open fires. Surely they were not all freezing cold. It must be a question of organization and technology too.

“It probably wasn’t so bad,” we replied. “They must have had their own tricks and secrets. For example, my grandfather heated up bricks on the stove and put them in his bed to warm it up. And it must have been cozy in the kitchen where they all gathered to keep warm. And think how much they appreciated it when spring came!”

The Daily Reckoning