RTH ETF: Betting Against Retailers

Retailers are one of the most sensitive sectors to an economic slowdown, and their stock prices generally tend to decline as consumers cut back on spending and competition increases. Retailers that rely heavily on consumer credit and have high levels of debt may be particularly vulnerable during an economic downturn. As such, shorting retail stocks can be a good strategy during an economic slowdown. Given the fact that we are at a turning point for economic growth, I believe that shorting the VanEck Vectors Retail ETF (NASDAQ:RTH) will turn out to be a profitable trade over the next 18 months.

About RTH

The SPDR S&P Retail ETF tracks the performance of the MVIS US Listed Retail 25 Index. The fund is designed to provide investors with exposure to the performance of companies in the retail industry, including those that operate in sectors such as apparel, department stores, and e-commerce.

The fund holds a diversified portfolio of companies in the retail industry, with the top holdings currently being companies such as Amazon (AMZN), Home Depot (HD), and Walmart (WMT). Below is a list of the top ten holdings, including their weights in the portfolio:

Valuation-wise, RTH trades at higher multiples compared to its category average. The fund currently has a TTM P/E ratio of ~20x and a P/B ratio of ~5x. While higher multiples could partly be justified by a higher historical EPS growth rate, I believe that RTH is trading an order of magnitude more expensive than other retail ETFs, which is something you should keep in mind.

For further details on RTH, please consult the fund’s prospectus.

Three Reasons Why RTH Is a Great Short Today

Retail stocks are always a great short when the economy starts slowing down. While Q4 2022 still shows signs of robust economic activity according to data from the Atlanta Fed, I believe that higher interest rates will ultimately impede short-term economic growth in the future. Below are my three reasons for shorting retail stocks over the next 12 to 18 months.

Weaker Consumer Spending

The first reason is that consumers tend to cut back on discretionary spending during tough economic times. This means that they will spend less money on items such as clothing, electronics, and home goods, which are often sold by retailers.

The Johnson Redbook Index, which is a measure of retail sales in the United States, has shown that comparable sales data has been trending lower in recent months. The index is considered a leading indicator of consumer spending, as it provides insight into the health of the retail sector.

While we are not yet seeing any negative growth in the retail sector, it’s an indicator worth keeping an eye on over the next quarters, as I suspect that growth will continue to trend lower. The fact that we’re in an environment where growth is losing momentum is a positive for shorts, as it suggests that there is still considerable downside risk for retail stocks going forward. On top of that, most of the negative returns experienced in recent months have been attributed to a revision of P/E multiples, while earnings held up remarkably well. At this point, it’s hard to see how this cycle ends up without retail earnings going lower.

Credit: Fueling the Post-COVID Retail Boom Now in Reverse

Retailers often rely on consumer credit to finance their operations. This means that consumers are less likely to take out loans or use credit cards to make purchases when they are struggling financially. This ultimately leads to a decline in sales for retailers and puts pressure on their stock prices.

Retail stocks have benefited from cheap credit in the post-COVID era, which fueled their sales and created supply shortages. Low-interest rates and government stimulus programs have allowed consumers to take out loans and use credit cards to make purchases, leading to increased demand for goods. Consumer loans, including credit cards, have reached a new all-time high, growing at twice the previous decade’s rate during the last two years. The increase in consumer debt was driven by low-interest rates and government stimulus programs, which have made it easier for consumers to take out loans and use credit cards to make purchases. However, with higher interest rates and quantitative tightening, we will now see some mean reversion in the consumer loans growth rate as we had in previous cycles, and that will ultimately have a negative impact on the retail industry.

Low savings rates in combination with high credit card spending are favorable to the bears. When consumers have low savings rates, they are more likely to rely on credit to make purchases. This leads to increased consumer debt, which can make it more difficult for consumers to make ends meet if they lose their jobs or experience a decline in income. Additionally, as consumers are forced to pay off their debt, they will have less disposable income to spend on discretionary items such as clothing, electronics, and home goods, which are often sold by retailers.

Competition Rising When Times Are Tough

Retailers often face increased competition during an economic slowdown. As consumers cut back on spending, retailers are generally forced to lower prices in order to attract customers. This leads to margin compression and lower profits. During the 2008-09 financial crisis, many retailers, such as Walmart and Target (TGT), cut prices on a wide range of items, including electronics, clothing, and home goods, in order to attract customers. Similar examples can be found in the early 2000s at JCPenney, Sears, and Kmart. While we haven’t seen many price cuts so far, I think it’s still one of the most important catalysts for the bear case. It also highlights the fact that bears are still at an early stage where more downside risk is building up in their favor.

How I Would Set Up the Trade

I think selling RTH short today provides a good risk/reward trade, especially against some of my longs. RTH is currently trading ~17% below its all-time highs and still ~70% above the March 2020 lows. Additionally, deteriorating economic growth should favor the bears going forward. I would apply the classic bear market playbook here: shorting on rallies and covering part of the position after a 10%-15% pullback.

Key Takeaways

Retailers are one of the most exposed industries to a slowing economy, making it a good hunting ground for short sellers. I believe that a combination of weaker consumer spending, deteriorating credit conditions, and higher competition in the space will ultimately put pressure on retail stocks. Given that we are at a crossroads for economic growth, I believe that RTH provides a good risk/reward opportunity over the next 18 months.