What happened

Shares of Overstock.com (BYON 7.13%), Williams-Sonoma (WSM 1.38%), and Warby Parker (WRBY -1.90%) rallied on Tuesday, rising 11.8%, 4.6%, and 7%, respectively, on the day.

As the markets rallied from July into August, it appears some speculative behavior is creeping back in, with meme-stock traders buying on any sliver of good news -- especially in heavily shorted stocks. 

For the beaten-down retail sector, that bit of good news came today in the form of Walmart's (WMT 1.85%) better-than-feared earnings report, as well as Home Depot's (HD -0.10%) revenue and earnings beat.

Coming into earnings season, many retail names -- like Overstock, Williams Sonoma, and Warby Parker -- had accumulated high short interest because of fear over consumer spending. Therefore, when Walmart and Home Depot outperformed, it appears that a fair amount of short covering occurred across the sector.

So what

While Walmart and Home Depot are behemoths, Overstock, Williams-Sonoma, and Warby Parker are more like niche retailers. Therefore, they might have been more susceptible to wild swings in results as consumers' budgets are squeezed by inflation. This is why their stocks were severely sold off in the first half of the year.

These three companies had so much pessimism around them that even when Warby Parker lowered its full-year guidance on its recent second-quarter earnings report last week, the stock actually surged. Overstock had also missed its second-quarter revenue and earnings back in late July.

Amid fears of a recession, especially in the retail segment of the economy, short-sellers were pressing their bets coming into today, with short interest rising to high-teens percentages of shares outstanding for these three stocks.

WRBY Percent of Shares Outstanding Short Chart

WRBY percent of shares outstanding sold short. Data by YCharts.

Therefore, when Walmart announced better-than-expected earnings results and raised its 2022 guidance, it was a bit of good news for the sector. The key seemed to be that Walmart management was raising guidance on operating income from a previous decline of 11% to 13% to a decline of 9% to 11%, reflecting better-than-expected performance in the second quarter.

When Home Depot, another large home-focused retailer, also reported revenue and earnings beats today (albeit off of low expectations), the entire mood around the retail sector brightened.

Overstock, Williams-Sonoma, and Warby Parker -- all specialty retailers -- were seen as even more susceptible to an economic downturn, given the somewhat discretionary nature of their merchandise. So unexpected good news is a recipe for a big short-covering rally like the one we had today.

Now what

Short-covering rallies can be tantalizing to chase, but they can also be dangerous. None of these three companies reported any material news today, so they could very well be having problems, even if Walmart and Home Depot aren't. But when market leaders like Walmart and Home Depot go one way, many stocks follow along even though they might not deserve to, because many investors tend to buy or sell the entire retail sector via exchange-traded funds.

On the other hand, for those looking to bottom-fish after this year's bear market, the retail sector is probably a good place to look. We are in a terrible environment now for consumer spending (particularly on home goods), but most stocks related to this segment have sold off a tremendous amount. Often times, stocks recover before their businesses do, as long as investors can see light at the end of the tunnel.

This month's better inflation numbers are certainly showing investors a potential path to better times ahead, and the stocks are bouncing accordingly. Just be aware we aren't out of the woods yet, and a lot of the movement in these three stocks will depend on macroeconomic issues like inflation and interest rates.