Summary
- The headline growth number of the recent retail sales report could make investors complacent.
- Inventories still look elevated, and we could see markdowns and gross margin pressures persist.
- Direxion Daily Retail Bull 3x Shares ETF's heightened sensitivity to volatility makes it a tricky bet as risk-off conditions gather steam.
Run lean; avoid unnecessary expenses. - Richard Branson
If you've been following some of the recent commentaries on the timeline of The Lead-Lag Report, you'd recognize that I've been highlighting how stocks belonging to the growth universe look to have lost their mojo.
Within that broad growth universe, you have the retail sector, which, prima facie, may give you the impression that all is well there, particularly as the most recent retail sales increase was the biggest in two years. Some of you may even be contemplating a leveraged bet in this sector by resorting to the Direxion Daily Retail Bull 3x Shares ETF ( RETL ), which attempts to provide 3x the "daily" return of the S&P Retail Select Industry Index. Before you jump the gun with this product, here are some things you should consider.
Conditions Are Not Ideal
On the face of it, the recent growth in retail sales was impressive, but it is questionable if this will last going forward, as the jump was likely driven by seasonality factors.
Structurally, the U.S. consumer is facing some tricky conditions, which would suggest that one ought to be cautious on this sector. Firstly, it looks like inflation is a lot more entrenched than one initially thought, and even if you think we are close to a peak, a recent survey by Deloitte highlighted that consumers remain concerned about high prices and the effect on purchasing power.
You wouldn't necessarily blame the average U.S. consumer when one of the most important components of his/her net worth-housing appears to be in a freefall. I touched upon what's driving the weakness with a couple of guests on a Lead-Lag Live episode .
Then you have the Fed desperately trying to put a lid on inflation, and last week's report only reiterate its long-standing hawkish positioning for the foreseeable future. The base case now is for 75bps of additional rate hikes, with the potential for this to even hit 100bps. Unsurprisingly, mortgage financing costs are now back to hitting some uncomfortable levels.
One does wonder about the debt servicing abilities of U.S. consumers in the face of higher rates, particularly as they continue to take on even more debt. As noted in The Lead-Lag Report, towards the end of last year, new consumer debt rose by 4x on a YoY basis.
In addition to weak consumer health, one also ought to consider that much of the recent retail sales momentum was likely driven by a strong promotional environment, particularly in categories such as apparel, which RETL's tracking index is heavily exposed to. These retailers don't have much of a choice as consumer spending intentions, particularly with discretionary categories, continue to plummet, so the only way to get a base-level volume is to ramp up the promotion lever. Unfortunately, this will reflect poorly on the gross margins of these retail entities.
Retailers such as Target (TGT) have been vocal in playing down any undue enthusiasm in the retail sector, stating that higher markdowns were very instrumental in driving down discretionary inventories towards the end of last year. If you recollect, much of the narrative in H2-22 was centered around how the inventory position of these retailers was weighing heavily on cash generation and the balance sheet. You would think this risk would have abated by now, but looking at the latest inventory/sales ratio across the retail sector, it appears that markdown pressures (and the corollary effect on gross margins) will persist in 2023 as the I/S ratio finished the year at its highest point!
Even if more promotions are pushed through, there's no guarantee that there will be any takers, particularly when you consider the bumbling state of consumer finances in the face of higher inflation, and higher cost of capital. The likes of Dollar Tree (DLTR) and Walmart (WMT) have already implied that purchasing habits have now shifted from discretionary items to food and consumables.
Conclusion
While conditions in the retail segment don't look too bright, the prospects for RETL look even more daunting when you consider the leveraged nature of this product and its susceptibility to volatility. On account of its daily reset nature, this is a product better suited for quick directional swings, rather than something you want to own for a prolonged period. I say this because, even during flattish movements, this product could end up burning a hole in your pocket if volatility conditions remain elevated.
The table above highlights that even if RETL's tracking index delivers no returns, you could still end up losing 3% when annualized volatility is 10%. With Direxion Daily Retail Bull 3x Shares ETF that is hardly the base case, as the annualized volatility of the ETF XRT has been around 37%; assuming a similar cadence going forward, and you could be looking at drawdowns of over 30% if the index remains flat over a year.
All in all, as noted in a post on the Lead-Lag Report's Instagram page, a volatility spike is not too far away, and you may first see this come through via credit spreads before it spills over to the equity markets. During times like this, you don't want to be overly exposed to a product like Direxion Daily Retail Bull 3x Shares ETF.
For further details see:
RETL ETF: Gloomy Conditions