3 Reasons to Buy Retail Stocks Now

This doesn't feel like a great time to be investing in retail.

However it gets resolved, the fiscal cliff promises to yank cash from consumers' paychecks by ending the payroll tax holiday for 2013. As for 2012, retailers may have just booked their worst holiday in years. And on top of that, one of the big benefits to owning consumer stocks -- that they directly pay back a huge portion of their earnings -- looks set to weaken as tax rates on dividends rise.

So retail is primed for an awful year ahead, right?

Not so fast. There are strong trends pushing consumers in the opposite direction, toward higher spending. And the holiday season that just passed probably wasn't as bad as you think. All told, now might be the perfect time to buy back into retail.

1. Two drags become one boost. 
For one thing, the big picture for consumers looks better than it has in years. It's been widely reported that unemployment is at its lowest point since late 2008. And far from being the drag on wealth that they've been for years, housing prices are finally bouncing back:

Source: Federal Reserve Economic Data.

But even more encouraging is the fact that debt costs are tanking. It's taken a while for consumers to bring down their balances to more manageable levels, but that painful process is working. After climbing to as high as 14% on the eve of the recession, the portion of income that people are dedicating to debt service is down to 10.5%, a decade low:

Source: Federal Reserve Economic Data.

So with housing pricing recovering and debt payments grabbing a smaller slice of the income pie, two of the biggest headwinds to consumer spending are clearing out of the way. And that's setting the stage for what could be a great 2013 for retailers.

2. A decent 2012 holiday season.
But investors don't need to bank solely on hopes for a brighter future for retail. The recent past looks pretty good, too. All the headlines last week trumpeted data that suggested weak holiday spending. The top-line number was grim. MasterCard's SpendingPulse found a slowdown in growth for the season, to 0.7% as compared to the 2% holiday boost that was logged last year. Considering how long the holiday season was this year, and how strong consumer confidence was heading into it, that would be a disappointment.

Still, that estimate could turn out to be low. The National Retail Federation is sticking by its projection for a 4.1% rise in spending this past year. And data from comScore suggest a massive 16% jump in online spending, which should benefit physical merchants too. Regardless of which of these estimates hits the mark, there will be plenty of retailers that report record holiday results this quarter.

3. The sector is getting cheaper.
But you wouldn't know it by looking at many of their stocks. Retailers, as a group, are sliding into the new year. Both the Dow Jones Retail Index and the S&P Retail Industry Index are down by 2% more than the market in December. And a handful of retailers were hit even harder than that. Here's a look at a few that had a particularly rough month to close out the holidays:

Source: Yahoo! Finance.

Now what?
To be sure, some of these companies deserved their holiday hit. Sears has been struggling with falling sales for some time, to the point where The Wall Street Journal named it as one of four retailers that face a do-or-die 2013. And Under Armour had room for a little pullback after jumping by 50% through October. The stock is still performing well for investors, though. It's up 33% on the year.

But why sell off names like Coach, Ralph Lauren, and Kohl's? Sure, Kohl's reported weak November sales. Revenue was down 5%. But now that the company is valued at less than 10 times earnings, the selling seems overdone. Ditto for luxury retailers Coach and Ralph Lauren. Both reported sales growth last quarter, and Ralph Lauren even managed to expand its operating margin. Yet at just 15 times earnings -- and down more than 30% from its highs on the year -- Coach seems like the best sale of the bunch.