Which Consumer Stocks Should You Buy Today?

As consumer confidence plummeted over the holiday shopping season and into the New Year, retail stocks naturally got hammered. Well-known names such as Ruby Tuesday, Office Depot (NYSE: ODP), and Borders Group (NYSE: BGP) traded for less than a dollar a share at their nadir on March 9, while formerly impressive brands like Circuit City and Linens 'n Things went flat-out bankrupt during this period.

While the retail outlook was pretty dire in March, the tide has turned in the last three months, reviving retail to a degree that Lazarus would envy. Since March 9, Ruby Tuesday is up an incredible 609%, Office Depot 761%, and Borders 750%.

The reasoning behind the rally? We've seen more positive (or rather, "less bad") economic data, which has seemingly convinced the market that the worst is over for both consumers and retailers.

Don't believe the hype
Let's not get ahead of ourselves here. It's true that consumer confidence recently hit an eight-month high, but the reading remains well below what economists consider healthy, and the deck remains stacked against consumers.

The biggest issue remains the suffocating level of existing debt on consumers' balance sheets. A recent article in the Harvard Business Review found that, among other things, "It would take consumers 1.3 years to pay down existing debt with their current after-tax income, provided they spent that income on absolutely nothing else." An optimist might note this figure is down slightly from 1.33 years in the first quarter of 2008, but I find that little reason to celebrate. It's still a long way from being a good figure -- by comparison, this measure stood at 0.6 years in 1975.

Compounding this problem, the economy continues to hemorrhage jobs. The ADP National Employment Report estimated that another 532,000 non-farm private jobs were lost in May alone, bringing the total to about 3 million since December 2008. The job cuts not only affect those who were actually laid off, but also those who weren't laid off and are worried about being next on the chopping block. People fearing for their job security are understandably less inclined to take on a mortgage or an auto loan.

Finally, to round out the consumer maelstrom, short-term credit (in the form of credit cards) is becoming less available. In December, banking analyst Meredith Whitney argued that credit card lines could be reduced by $2 trillion over the subsequent 18 months, marking a 45% reduction in available liquidity. New regulations for the credit card industry, signed into law by President Obama, could make credit even harder to come by.

The basic fact remains that American consumers are mired in debt, and increasingly putting whatever cash they can spare into savings. And when consumers are deleveraging, they aren't going on luxurious shopping sprees, taking exotic vacations, or, as both Home Depot (NYSE: HD) and Costco Wholesale (Nasdaq: COST) recently noted, making big-ticket appliance purchases. All of this makes a consumer-driven recovery highly unlikely.

What to buy
None of this means that you should avoid the entire retail sector, or that American consumers won't continue to spend. Quite the contrary, actually. According to Nielsen market research, U.S. consumers are indeed shopping less overall, but they are buying more value brands.

Simply consider the wide discrepancy in the May same-store sales figures between high-end teen retailers and more value-oriented competitors:

This trend towards thrift will be lasting, too. Even with historically low interest rates and trillions of dollars worth of government stimulus and incentives to encourage spending, American consumers remain hesitant or unable to finance bigger-ticket expenditures. Until consumers can adequately deleverage -- which, as the Harvard study made very clear, could take years -- a sustainable recovery in discretionary spending simply cannot take place.  

Foolish bottom line
If you're going to buy a consumer stock today, focus on companies that offer value over style and needs over wants. One of the few retailers we've liked at Motley Fool Pro is Tractor Supply, a "rural-lifestyle" retailer that sells a wide range of goods, from livestock and pet supplies to garden tools to, yes, tractor supplies. Despite the significant changes in consumer behavior during this recession, Tractor Supply has increased sales by focusing on "consumable, edible, and usable" products that people need in their everyday lives. Additionally, Tractor Supply remains operationally efficient, retains a balance sheet with no long-term debt, and still has plenty of room for expansion.

While there are a few retailers, like Tractor Supply, that we would consider buying, we continue to be concerned about the state of the consumer, and we're skeptical of the recent rally in retail. Fortunately, in our $1 million real-money portfolio, we can use options and ETFs to take advantage of a downward move in retail stocks.  If you'd like to learn more about what we do at Motley Fool Pro, simply enter your email address in the box below.