Wal-Mart, Moody's and GE Show That Consumers Are Living on Borrowed Time

After softness on Tuesday and Wednesday, the major U.S. indices jumped 2% on Thursday to record levels. The market is mixed on Friday due to disappointing retail sales, but the S&P 500 should finish the week with a gain of about 1.1%. The catalyst for this week's big move was bullish retail data on Thursday and news of a $38-billion bid from Rio Tinto PLC (RTP@RTP | Quote | Chart | News | PowerRating) for Alcan Inc. (AL@AL | Quote | Chart | News | PowerRating). Granted, there are signs that the river of deal flow is slowing. But it certainly hasn't stopped flowing with news on Friday that an activist investor has taken a large position in Target (TGT@TGT | Quote | Chart | News | PowerRating). This may or may not result in a private equity play on the retail giant, but it has already boosted Target shares to within 1% of their 52-week high.

Nevertheless, the outlook is not rosy for all things retail. On Friday morning the Commerce Department reported a 0.9% drop in retail sales. Wall Street had expected flat sales, so the data are putting a damper on investor enthusiasm. In fact, I think that investor concerns about growth are weighing on Wal-Mart shares, which rose only modestly on Thursday despite a big market rally and the announcement of strong sales for June. I believe investors are concerned about two big clouds on the horizon for consumer spending: Oil prices and real estate.

Gas Prices Pinch Wallets

Crude oil prices remain stubbornly high at almost $73 per barrel, and national gasoline prices finished June at over $3.00 per gallon. This is a big red flag for retail sales. High gas prices during summer driving season are leaving consumers with less money to spend at the mall. For June, investors had feared that retail sales would slow to a pace of 1.5% to 2.0%. Fortunately, the news on Thursday was better than expected: A survey of large U.S. retailers showed June growth of 2.4%, including a 2.4% gain in sales at industry giant Wal-Mart (WMT@WMT | Quote | Chart | News | PowerRating). So for now it seems that the overextended U.S. consumer will live to shop another day.

Subprime Saga Continues

The stock market is also shrugging off ominous signs about the mortgage market. Earlier this week Standard and Poor's and Moody's Corp. (MCO@MCO | Quote | Chart | News | PowerRating) downgraded hundreds of subprime bonds. Critics say that the bond rating firms are locking the doors after the subprime horses have left the barn. Indeed, Friday brought more bad news in real estate as General Electric (GE@GE | Quote | Chart | News | PowerRating) announced that it will sell its subprime unit. This business lost money in the second quarter, and rising delinquencies across the subprime landscape make further losses likely.

PowerRatings for Stocks In the News

What is the outlook for these stocks? The PowerRatings (for Investors) of these stocks vary widely:

General Electric has the highest PowerRating (for Investors) with a rating of 9, and the other attractively rated stocks are Wal-Mart and Target, two retailers. A rating of 10 is highest, and our data from 1995 through 2006 show that stocks with high PowerRatings have historically outperformed over the next twelve months. So for long-term investors the short-term challenges at GE, Target, and Wal-Mart could prove to be an opportunity.

The Credit Cycle Is Not Dead

As I discussed last week, the key to the outlook for U.S. equities is the credit cycle. High global liquidity has led to over $300 billion of deals during the first half of 2007, a record pace. And real estate has been the key driver of consumer credit during the current expansion in the U.S. economy. Eventually, subprime problems will hurt investor sentiment and bond spreads, and the credit cycle will turn from a tailwind into a headwind.

Why hasn't this happened already? With rising gas prices and falling housing activity, what has supported consumer spending over the last six months? Job growth. Non-farm payrolls have continued to expand, and the unemployment rate remains low. This is exactly what you would expect at the end of a long economic expansion. There is still lots of liquidity in the system, and this is driving strong demand and strong economic growth. Unfortunately, this eventually leads to wage pressures and deeply embedded inflation.

Credit problems take a long time to fully emerge. Problems spread from weak borrowers to strong borrowers, and from complex derivative products to the mainstream bond market. As this happens, sentiment about credit starts to turn sour, and bond spreads rise for all forms of risky credit.

As for real estate, it takes a long time for residential markets to adjust to lower prices. People hate taking losses on their homes, so they take them off the market instead. This makes real estate prices "sticky downward," which is how Keynes described wages (people don't like to take pay pay cuts, either). When people take homes off the market, it is difficult to get an accurate picture of housing prices, so the magnitude of the depth of the real estate recession is not fully evident.

The combination of these forces is going to make the downturn in the credit cycle a protracted, messy affair. For stock investors, it is important to remember that one week's rally does not mean that the laws of economics have been rewritten. Easy money has been the engine driving the U.S. economy, and the engine is now stalling. Stock prices are likely to follow suit, so it's more important than ever to emphasize stocks with attractive PowerRatings.

Rob Martorana, CFA, is Director of Content for PowerRatings.net.

Rob was most recently at TheStreet.com as the Director of Content for Professional Products. Rob has spent 22 years on Wall Street, and was a portfolio manager and head of U.S. equity research at Barclays Private Bank. Robert also managed small-cap stocks at Schroder Capital Management International, was an equity analyst at Vontobel USA, and was an editor and senior industry analyst for The Value Line Investment Survey.