‘Tis the season to be jolly!

October 15, 2008

Or is it? U.S. retail sales recorded their biggest monthly drop in more than three years last month, indicating retailers will be singing a much different song this holiday season.

The Commerce Department said in its report released Wednesday that retail sales fell 1.2% in September, intensifying fears of a recession. Economists had expected a 0.7% decline, so the actual figure was almost twice as bad.

Although retail sales saw their sharpest drop since August 2005, inflation woes eased up as the Labor Department reported that U.S. wholesale prices dropped 0.4% in September. With economic growth looking shaky and inflation cooling off, I am now convinced more than ever that the Federal Reserve will further reduce interest rates at its next FOMC meeting later this month to fight off a looming recession and negative GDP growth for the current quarter.

Rate cuts by the Fed are one of the few weapons left to combat the toll the 14-month-old credit crisis has taken on consumer confidence. You have to remember that consumer spending accounts for nearly 70% of the economy, so these numbers have wide-reaching affects. In the last month, it seems that consumers cut down on everything except healthcare products and gasoline!

Obviously, Wednesday's report doesn't bode wells for retailers who've come to rely on the holiday season for a much anticipated revenue boost. Analysts are predicting that this year could mark the slowest growth in holiday retail sales since 2002. Both shoppers and stores are struggling to make ends meet as tighter credit restrictions are squeezing suppliers and buyers.

As investors, this grim retail sales outlook certainly narrows the scope of stocks for us to buy with money-making potential—but doesn't mean picking a winner is impossible!

In general, analysts expect value-oriented stores to be the safest bets this season, and the world's largest retailer, Wal-Mart (WMT), is leading the pack. The company maintained its third-quarter profit forecast and expects its low-priced, high value merchandise to position it well into the holidays even as shoppers think twice about how to spend their money.

My best advice to you is to steer clear from the retailers who depend on holiday sales for 50% of their annual profits. The reality is we could see a lot of names disappear in the coming months. If retail companies can't turn a healthy profit, banks will be even less willing to lend and may go so far as to yank their credit lines all together—and retailers rely on credit to buy merchandise.

So you're best bet in the coming months—if you're looking to invest in a retail company or two that's positioned to do well this holiday season—is to buy shares of big discounters like Wal-Mart and Costco (COST) that are benefiting as cash-strapped consumers buy up lower-priced goods. If you're not sure which companies have strong fundamental value, just plug their ticker symbols into PortfolioGrader Pro and check out the grades! (For a breakdown of each grade's importance, click here.)