Are We On The Brink Of A Retail Spending Boom?

Thanks, Old Man Winter. Consumers have already been in a sour mood, and you're not helping matters. Icy roads and bitter winds have left many people to stay at home -- and keep their cash in their pocket.

For companies that have been looking for signs that retail spending is finally ready to grow, this roadblock has been unwelcome. The bleak winter likely explains why retail spending on goods and services like cars, restaurants and gas stations slipped 0.4% in January on a seasonally adjusted basis, according to the National Retail Federation.

Yet before you conclude that the era of robust consumer spending will never return, consider an interesting stat offered up by J.P. Morgan: In just the past two years, consumers' net worth has expanded by $13 trillion.

So if consumers have stronger balance sheets, why aren't they spending? The key takeaway from these economists: "It is our view this is likely just a delayed reaction and that the increase in net worth will ultimately translate into stronger spending."

To be sure, much of the increase in wealth is attributable to a surging stock market. Many may feel that such gains are ephemeral, especially after seeing their net worth decimated in 2000 and again in 2008. The stock market's recent wobbles briefly pushed bullish investor sentiment below 30% in early February though sentiment has since improved.

But the other side of the consumer balance sheet ledger also merits attention. Consumers continue to reduce their debt burdens: the household debt service ratio (fixed payments as a percentage of income) is at its lowest level since 1985, according to the Census Bureau.

That's why economists predict that when consumers start to feel more confident, they will have even more financial firepower at their disposal. Instead of reducing debt further, they may grow comfortable taking on more debt, especially as employment trends strengthen. The view from J.P. Morgan's economists: "As leverage increases in coming quarters, we would expect this to further accelerate investment spending."

The current backdrop of bleak consumer spending and the future backdrop of improved spending means that investors need to refocus their attention on companies that stand to benefit from a more vigorous consumer. Here's a quick overview.

Automakers

In recent months, investors have grown concerned that the impressive rebound in U.S. vehicle sales is beginning to peter out. Shares of GM (NYSE: GM) and Ford (NYSE: F) have slipped more than 10% since mid-December, and these automaker's shares now trade for 12 and 9 times trailing profits, respectively.

Exclude their impressive net cash balances, and these stocks are even cheaper. A similar logic applies to leading auto parts suppliers.

To be sure, the tough winter has led to tepid sales in January for these automakers and suppliers, but investors shouldn't assume that sales have hit a ceiling. "We are estimating that the next peak in US auto sales will be 18 million around 2018, well above the current pace in the high 15 millions," predict analysts at Merrill Lynch. The fact that these automakers and their suppliers have endured a brutal stretch in Europe means that a torrent of pent-up demand in that market is waiting to be released as well.

Struggling Niche Retailers

Teenagers have been virtually absent during this economic recovery. Teen-focused retailer such as Aeropostale (NYSE: ARO), American Eagle Outfitters (NYSE: AEO), Zumiez (Nasdaq: ZUMZ) and Abercrombie Fitch (NYSE: ANF) all trade far from their 52-week highs as they wrestle with negative sales comps. To be sure, some these companies' woes are self-inflicted.

To regain investor interest, these retailers need to show a better hand at merchandising, but they also must await a brighter spending mood. As noted earlier, parents of teens are financially stronger, and spring weather could lead to a more positive mood. American Eagle, with more than $350 million in net cash, has the financial strength to support its stock. This article from Seeking Alpha helps explain why the company's emphasis on dividends and buybacks should help boost appeal with investors.

Homebuilders

I've largely avoided writing about homebuilders over the past year, largely because the group seemed to get ahead of itself in 2013, even as the housing market started to lose steam. The tough winter shows that 2014 is off to a rough start as well: New housing starts fell 16% sequentially, on a seasonally-adjusted basis, according to the Census Bureau.

Yet a recent meeting of the National Association of Homebuilders (NAHB) held in Las Vegas, panelists predicted that housing starts would rise 15% this year. And we could see similar sustained growth in 2015 and 2016 as employment trends continue to strengthen. J.P. Morgan's economists note that banks have begun to modestly loosen lending standards, requiring slightly lower FICO scores as consumers start to show more prudence.

No one expects a return to the go-go lending era of 2006 and 2007, but instead we should see lending policies that simply represent prudent risks. Wells Fargo (NYSE: WFC) is the U.S. bank with the greatest exposure to the mortgage market, though Citigroup (NYSE: C) is my preferred name in the group, as shares have moved back down below tangible book value recently.

Among the homebuilders themselves, Toll Brothers (NYSE: TOL) is very well-positioned, as the higher end of the housing market is showing the most vigor.

In the mid-tier of the market, KB Home (NYSE: KBH) merits a fresh look, after its shares have fallen roughly 25% from the 52-week high. Analysts at Merrill Lynch, who rate shares a "buy" with a $24 price target, think "this decline provides investors with an even more attractive entry point for a company that still has solid growth and profitability ahead of it. In fact, KBH intends to increase its community count by 10-20% in F14, with growth targeted for land constrained California."

Risks to Consider: Despite strong balance sheets, consumers still feel insecure. An improvement in consumer confidence is crucial if consumers are to start spending in line with their strong financial positions.

Action to Take -- When it comes to stock selection, investors can focus on leading firms that have performed well through the first phase of the economic rebound. Few bargains abound among such high-quality players. Greater upside is likely to come from retailers that have stumbled badly. That makes this a good time to start heavily researching currently struggling retailers to identify which ones are talking the right steps to win back consumers. This is a sector that often hosts great turnaround opportunities.

In addition to the companies noted above, I'm also keeping a close eye on Best Buy (NYSE: BBY), Bed, Bath Beyond (Nasdaq: BBBY), RadioShack (NYSE: RSH) and Francesca's Holdings (Nasdaq: FRAN).

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