An October Christmas for retail stocks

Consumers are still watching their wallets, but compared to last year, retailers are in pretty good shape for the upcoming shopping boom.

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By Suzanne Kapner, writer

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NEW YORK (Fortune) -- Christmas has come early for retail stocks. The Standard & Poor's Retail Index is up 72% from its lows in March, compared with a 61% gain in the broader S&P 500 Index over the same period.

Some companies have even started to raise guidance. After reporting stronger-than-expected September sales, TJX Cos. (TJX, Fortune 500) said it now expects to earn more in the third and fourth quarters than previously anticipated.

Yet, no one is projecting a blowout holiday season. What's going on?

Despite the continued mood of frugality that has gripped the country and put a damper on consumer spending, retailers have a few things going for them. Namely:

Sales, while still anemic compared with the recent go-go years, have been stronger than expected. September same-store sales, or sales at locations open more than a year, grew a scant 1.1%, but that was better than the expectation for a 0.8% decline, according to Retail Metrics.

Although September results were buoyed by easy comparisons from a year ago, they marked their first monthly gain since August 2008, a sign that retailers may be starting to turn the corner.

Anecdotal evidence suggests that October will be another strong month. Moreover, the National Retail Federation predicts that holiday sales will fall only 1% to $437.6 billion -- far better than the 3.4% decline we saw last year.

The consumer is in better shape. To be sure, high unemployment and a decline in wages and house prices continue to weigh heavily on consumer spending.

But compared with a year ago, many consumers have a financial cushion. Credit card debt is down nearly 8% over the past year, and the savings rate has doubled, according to Economy.com.

Plus, there is pent up demand. After depriving themselves all year, shoppers are ready to treat themselves in small ways again.

Retailers have less inventory. Stores have spent the past year drastically reducing their stock cutting inventory in anticipation of lower sales. That means they are entering this holiday season in a much stronger position. Leaner inventories allow merchants sell more goods at full price -- which boosts profits.

"Retailers have a lot of things working for them going into this holiday season," says Stifel Nicolaus analyst Richard Jaffe. "And that optimism has been priced into a lot of the stocks."

Also helping to push the stocks higher: Retailers tend to benefit in the early stages of an economic recovery, which is one reason why investors have been piling into the group now, just as the economy appears to be pulling out of the recession.

"If you find an extra $20 in your pocket, you're not going to go out and buy a new car," Jaffe says. "But you might buy a pair of jeans or a new sweater."

For similar reasons the NPD Group expects traditional apparel items such as sweaters to be among the top gifts this holiday season, after losing ground in past years to electronic gadgets. In a recent report, NPD went so far as to call apparel a "bright spot."

That type of spending should help specialty retailers, but not all of them are created equally. Here are some of Jaffe's picks and pans:

Picks

The Children's Place (PLCE): Investors have overlooked the children's apparel retailer, which has $7.50 a share in cash and no debt, because of a public battle with its former CEO, who was ousted for violating ethics policies and then tried unsuccessfully to buy the company.

Gap (GPS, Fortune 500): After years of sluggish sales, the maker of denim and khakis is showing some life

Urban Outfitters (URBN): The maker of baby doll dresses, denim and appliquéd sweaters continues to connect with trendy twentysomethings through its namesake brand as well as Anthropology, a sister chain.

Pans

Talbots (TLB): The shares are up more than threefold since January, but the company continues to lose money.

J. Crew (JCG): Shares of the maker of preppy clothes with a twist have become too expensive, trading at 24 times 2010 earnings.

Lululemon Athletica (LULU): The company is retrenching after growing too fast. To top of page

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Yahoo! Inc 40.93 -1.16 -2.74%
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Oracle Corp 39.80 -1.75 -4.21%
Facebook Inc 77.91 0.91 1.18%
Data as of Sep 19
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Treasuries 2.59 -0.04 -1.60%
Data as of 8:28am ET
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