Consider Retail Into Year-End

Retail stocks fell hard in July and bounced in August along with the broad market. The subsequent recovery was encouraging, but the move fell apart a full month before the major averages topped out in October. Selling pressure has been intense since the selloff began, with investors dumping these issues in anticipation of slowing growth in 2008.

Expectations for the holiday season have dropped like a rock as well, with analysts now expecting consumers to hold on to their wallets through year-end. This paranoia makes sense, given the weak monthly sales data posted last week. But at some point, negative sentiment will shoot past reality and mark the start of a strong sector recovery.

The Retail HOLDRs dropped to $93 at the August low and then bounced back to $105 in mid-September. This price level marked the 78% retracement of the July-to-August decline. After breaking August support, the ETF then sold off in a vertical decline and dropped to a 14-month low last week.

Ironically, this washout could mark the end of the downtrend, at least into the second quarter of 2008. The selloff has reached major support at a rising channel set into place more than three years ago. Add this to the trend line created by the cascading lows posted in the last eight months, and the $90 level looks like a major inflection point.

No, this isn't a buy call, at least yet. Rather, it's wake-up call to get these stocks back onto your trading screens, because buyers could return in force as we approach year-end. How can I make this prediction? The last three lows marked out identical V-like patterns, in which the upside redeveloped quickly after the sector hit its final low print.

The retailers have sold off longer and deeper than the S&P 500 index, and this raises the likelihood that the sector will bottom out ahead of the blue chips. As I noted on Monday, the blue chips could reach that turning point in the next one or two weeks. This raises another interesting question: Why will speculation in retail stocks be worth the effort if other market groups start to recover?

The answer lies in positive seasonality. These stocks would be enjoying the height of their speculative fervor if this were a "normal" year. Holiday ads hit the airwaves just last week, and market players would be placing bets on the companies most likely to benefit from the busiest sales period of the year.

That hasn't happened in 2007, at least so far, because macro issues have overwhelmed seasonal speculation. Consider how things might change if that heavy weight lifts off the broad market for a few weeks. The sector might even play catch-up as mall traffic and sales receipts gather renewed attention.

No, I don't expect a fabulous holiday season with record cash register sales. Rather, I suspect the negative sentiment that's been tearing down expectations may have overshot its mark, setting up substantial upside on relatively good news. In that regard, let's look at two retailers that could benefit most from a sector bounce into year-end.

Costco shows the most bullish chart of all major retailers. The stock broke out above seven-year resistance in July, when it rallied above $61. It's been tough going since then, with a stair-step pattern that has triggered two choppy looking clusters. But price has held the breakout despite the volatility and shows signs of wanting to move higher.

Persistent buying interest through the broad downturn marks a strongly positive divergence. Keep things simple and buy the breakout above the three highs generated by the most recent congestion pattern. A rally through that level should initiate an uptrend that releases the stock from the choppy price action and sends it into the mid-$70s.

Blue Nile is an online jeweler that rallied to an all-time high at $106 in September and sold off with the sector. It dropped to two-month support in the low $70s last week and started to bounce. That move accelerated on high volume after the company reported strong earnings. The rally has now paused at resistance at its 50-day moving average.

Accumulation has remained strong on this retailer despite selling off almost 35 points. This is setting up a strong run back toward triple digits, but timing is everything on this recovery play. Notice the broad October gap between $91 and $100. It's best to take profits when the stock fills that big hole and tests the round number 1$00.