Approximately 70% of U.S. GDP (Gross Domestic Product) is created for personal consumption. ^[1] As consumption is such a large component of our economy, it is prudent for us, as investors, to have some tools to monitor consumption--both for insight into the broader market trend and trends in sectors more sensitive to changes in personal consumption, such as retail.

Here is one method of doing just that using the retail sales data series as compiled and published by the U.S. Census Bureau. This series aims to give a snapshot of monthly sales figures for various kinds of retail markets. As you might expect, this data is quite seasonal and volatile. Unfortunately, the financial press tends to focus on quarter over quarter (QoQ) change in seasonally adjusted figures when reporting retail sales, which makes it difficult to discern a trend. However, I find it helpful to use year over year change in the non-seasonally adjusted numbers instead as well as a three month trailing average (TTM). What you will end up with is a chart like the one below from 1994 through the present. (Click the image for a larger version).

From this chart we can draw several conclusions. First, greater than 8% TTM growth is an area indicating a possible upcoming correction. Less than 4% TTM growth signals a possible bottom (though it spiked as low as 1% TTM in the bad bear market of 2000-2001). Also, you can see that retail sales have been trending up from our 3-4% bottom signal.

So you ask, how might this help us time entries into retail stocks? Well, let's take a look at how our retail sales figures gel with our proxy for consumer cyclical stocks--the Consumer Discretionary ETF (XLY). The following chart overlays retail sales with XLY from 1999 to the present. (Click the image for a larger version.)

You can see a clear correlation between the trends in retail sales and XLY. In fact, retails sales appear to be a pretty good leading indicator of the performance of stocks sensitive to consumer discretionary spending--with a lead time of 12 to 16 months.

Most compelling is the reversal of our indicator in November 2001 after a prolonged downtrend, the effects of which are seen in XLY beginning in March 2003--16 months later. This situation is now happening again. Our indicator bottomed in November 2006 after plunging 4 percentage points and XLY traced out the beginnings of a possible bottom this past March.

Several retail stocks are already showing strong signs of recovery. Urban Outfitters (URBN) and Aeropostale (ARO) are both sporting accelerating sales and earnings growth over the past several quarters. Both are building possible handles to their current bases with support around 32 to 33. Nike (NKE) has been building a flat base, trading between 66 and 69 since a strong breakout from a cup with handle base. It's been outperforming the S&P the past month, despite trading sideways.

I'm not sure it'd be wise to buy into these stocks quite yet however, given the current market conditions. URBN and ARO are due to report Q2 numbers in August. Historically, Q2 has been a weak quarter, with Q3 (back to school) and Q4 (Christmas) making up the bulk of annual earnings. They should definitely be on your watchlist though. If you do decide to trade these breakouts, be nimble and willing to take profits while you still have them...

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