What happened

The specialty retailing category was hit hard during a down week on the stock market. Five Below (FIVE 0.51%), Ross Stores (ROST -0.36%), and The Container Store (TCS -1.23%) fell 12%, 9%, and 16%, respectively, through Thursday trading compared to a 3.2% decline in the wider S&P 500, according to data provided by S&P Global Market Intelligence. The drops added to big declines for these stocks, which are all down by more than 35% so far in 2022.

It came as investors began to worry more about rising inventory risks ahead of a potential downturn in consumer spending.

So what

None of these companies issued operating updates this week. But investors did get some indications of a worsening demand environment from Nike's Monday report.

The footwear and apparel giant said that sales trends looked solid through late May but warned that profitability would likely fall further in the current quarter thanks to rising costs. Smaller specialty retailers like Five Below might be more exposed to these margin pressures that are coming from supply chain challenges and generally rising prices.

Investors have already seen evidence of declining earnings power in these stocks. The Container Store reported a gross margin drop in its mid-May report, which management blamed on rising commodity and freight costs. Ross Stores at the same time announced falling earnings when its management team lowered its 2022 outlook. Five Below said in early June that its core profit margin fell to 6.6% of sales from 10.6% a year earlier.

But investors have a potentially bigger concern right now that was illustrated in Nike's Monday report. Most retailers have been busy building up bigger inventory holdings in hopes of circumventing many of the supply chain challenges that have impacted their business for the past year. They have been succeeding, too, as Nike achieved an over 20% boost in its inventory.

But these supply wins might have come at a dangerous time as consumer spending levels potentially worsen. The combination of higher inventory and weakening demand could make for a difficult second half of 2022 ahead for these specialty retailers.

Now what

Five Below, Ross Stores, and The Container Store each serve different markets and have unique competitive strengths and weaknesses. Those factors suggest that investors might be getting carried away by pushing their stocks down simply on wider worries about the health of consumer spending.

However, it is also true that the retailing industry is facing a period of elevated risk as companies approach the holiday shopping period with high inventories. Management teams, from Nike to Five Below, have described these holdings as high quality, meaning they represent fresh products that executives believe will be in high demand over the coming months.

But it's still possible that other retailers will follow the path that Target did in recently reporting an uptick in price cuts and inventory write-downs in response to a surprise demand shift. During a down week for the wider market, that prospect of potentially weaker earnings spooked shareholders of Five Below, Ross Stores, and The Container Store stocks.