The news for US retailers is grim to say the least. But Justice Litle says investors can still make profits by shorting the most vulnerable firms in the industry. He picks three retail stocks that look overvalued in today’s climate.

This from Taipan Daily

At market extremes (where fortunes are most often won and lost), the wild outliers get closer to reality. Such is the case with the “mega-mall ghost town” scenario.

In the past two weeks, the financial press has been chock-a-block with headlines like “Commercial Property Loses Shelter” and “Struggling Retailers Press Struggling Landlords on Rent.”

“U.S. retailers are expected to begin a wave of post-holiday bankruptcy filings,” the Wall Street Journal writes, “altering the landscape at malls and on main streets across the country.”

One mall store manager – who requested his name not be mentioned – told the WSJ he expects more returns than sales on some days. “We’ll have $5,000 in sales and $7,000 in returns,” he said.

It should be no real surprise, then, to hear that the Consumer Confidence Index just hit an all-time low of 29.4.

As the Trader’s Narrative blog points out, “That’s lower than the 2002 bear market bottom. Lower than the confidence level in 1991. Lower than the early 1980s. Even slightly lower than darkest days of the 1970s bear market.”

And finally, at risk of beating the point into the ground with a flathead shovel, take a look at this Financial Times chart.

That chart only goes back to 1993. If you were to extend it many decades further, you would find that the latest number for U.S. retail sales was the worst in sixty years.

What to Do?

Some say these numbers are so bad they can only get better. I’m not sure I agree. While certain areas of the market are set for a strong bounceback in the coming months, the U.S. consumer’s wallet probably isn’t one of them.

The dire state of the American retail landscape highlights the importance of being selective, on both the investing and trading side, as we head into the post-apocalyptic landscape of 2009 and beyond.

A key task will be sorting out two kinds of stocks: those that are truly once-in-a-lifetime cheap… and those whose consumer-linked business models are “permanently impaired.”

On the trading side, one go-to idea is shorting RTH:AMEX, the Retail Holders ETF.

This is a trade that could make some money, but I can’t help but think there are better ways to play it.

I’m not crazy about being short Wal-Mart (NYSE:WMT), for one – the single-largest component of the RTH index. True, WMT recently gapped down big on lower-than-expected sales… but the Beast from Bentonville has a price to earnings ratio of less than 15, and is more likely to prove a long-term winner than loser in the great retail shakeout.

Another point in Wal-Mart’s favor: they sell stuff that people need to buy. U.S. consumers aren’t about to stop ponying up for toothpaste and diapers and socks, no matter how gloomy the big picture gets.

Why not instead, then, cast a bearish eye on a company like Amazon.com Inc. (Nasdaq:AMZ), which still supports a price-to-earnings multiple of 34 and sells “discretionary” type items (books, CDs, videos, etc.) that people don’t really need?

Sacred Growth Cows

Shorting is a bit like value investing in reverse. As a value investor, you want to find companies that are cheap relative to assets, cash flow and long-term prospects for growth.

As a short seller, you want to hunt down companies with the opposite profile… valuations that are inflated, prospects that are over-hyped, and multiples that don’t make sense.

Zach and I jokingly refer to these crash-and-burn candidates as “sacred growth cows.” When investors fall in love with a concept stock or a great growth story, they often find it hard to let go of their rosy outlook… even when market action suggests strongly that they do so.

I asked Zach if he had any “sacred growth cows” on his radar screen for Death Cross Trader. As usual, he was happy to share a few names off the top of his mental rolodex. Here’s a sample of what he came back with.

1) Blue Nile Inc. (Nasdaq:NILE). Blue Nile is “an online retailer of diamonds and jewelry” with a roughly $300MM market cap.

The idea of buying your sweetie a piece of bling via the World Wide Web never made much sense to me. Per Zach, the NILE business model makes even less sense in this harsh climate.

“The stock still trades in the 20 to 24 times earnings range,” Zach notes, “because investors believe the rich will still buy diamonds.”

Leaving aside whether that’s true, Zach points out that it isn’t even relevant to NILE’s true business model. “These guys actually cater to the Joe Sixpacks of the world… the guys looking to spend $5,000 or less on an engagement ring. Ticket prices are falling and lower sales figures are coming in, yet NILE is still priced like a growth stock.”

2) Under Armor Inc. (NYSE:UA). Under Armor is a wannabe Nike, selling “branded performance products for men, women and youth.” It currently sports an approximate $1 billion market cap.

“Under Armor’s growth areas,” Zach notes, “are supposedly in running shoes, basketball gear, and other categories that could all be seriously hampered by consumer spending cutbacks. Under Armor made its name in football gear, but football season is now over. The company should have seen its best quarter in Q408, but they’re reporting weakness instead.”

Another big problem for Under Armor is the bruising nature of the competition. As times get tougher, the real Nike – sporting a P/E of less than 13 and a market cap of $23 billion – could put the big hurt on its tiny rival.

“It’s pretty scary to see analysts ratchet down earnings expectations by 20% overnight,” Zach says. It might not be the last time for UA.

3) Mystery Coffee Producer.

Zach didn’t want me to reveal the third name because he is working it up for a Death Cross Trader short.

This high flyer, soon to crash and burn, has a market cap of $840MM and an eye-watering P/E of 39 times earnings… pretty hard to justify in a consumer armageddon environment. The company makes its beans (bad pun intended) in the “specialty coffee industry,” selling more than 100 varieties of “whole bean and ground coffee selections.”

I don’t know about you, but it seems intuitive to me that with consumers retrenching, fancy-dancy coffee could well be one of the first items to go.

“To get a roadmap of how I expect this one to trade,” Zach says, “simply pull up a weekly chart of Starbucks (Nasdaq:SBUX). Consumers are fickle, and these hoity-toity coffee guys are a fad.”

“Fad stocks are fun to be long in bull markets… and they’re even more fun to be SHORT in bear markets when they drop like rocks.”

Source: A Heaping Helping of Retail Fail