Retail’s revenge

Americans love stories about self-made men who built their business empires on sweat and ingenuity. Titans like Andrew Carnegie, Henry Ford, Warren Buffet and Bill Gates, and now it seems Jeff Bezos has joined their ranks. Nothing has captivated investors like Amazon’s (AMZN) share price cresting at $1,000, generating annualized returns close to 29% during the last decade and briefly making Bezos the richest man in the world in the process. Small wonder that so many are willing to overlook that Amazon only recently became profitable, thanks to cloud computing, not retail. And even then, its profit margin is so thin that buying a supermarket chain—the epitome of a low-margin business—like Whole Foods (WFM) will actually drag it higher.

However, we’re not here to talk whether Amazon is still a good investment, but to point out that in a market addicted to stories, the company’s phenomenal growth has reached a point so extreme that exchange-traded fund heavyweight ProShare Advisors has filed paperwork with the Securities and Exchange Commission to create several new funds that are long online/short brick and mortar retailers in both an unlevered and 2x or 3x levered format to help investors reap more profits from the industry’s inevitable passing. But while most are blinded by Amazon’s success, a few remember that the best time to buy is often when there’s blood in the street and there’s no bloodier part of the market right now than retail.

A year ago, we talked about looking for overlooked bargains and coming up with nothing but depressed retailers, not much has changed (see “Amazon, arbitrage & retail ETFs,” Modern Trader, August 2016). Even the biggest brick-and-mortar retailers like Wal-Mart (WMT) and Home Depot (HD) are lucky if their stock prices are positive and only trailing Amazon’s by less than 20% compared to the previous year. But that relative lack of performance has only helped to make retailers relatively more attractive, and even as Amazon geared up for its last big push to $1,000, the largest dedicated retail ETF (the SPDR S&P Retail ETF (XRT)) found a double bottom and it wasn’t thanks to its 1.1% allocation to Amazon.

We mentioned in that article that XRT is an equally-weighted fund where the close to 100 holdings start with same weight in the portfolio after each rebalancing, which means more volatile small-cap stocks play a much larger role in the portfolio than in market-cap weighted funds like the Consumer Discretionary Select Sector SPDR Fund (XLY) or the VanEck Vectors Retail ETF (RTH) where bigger names rule the roost; with 16% and 20% of their respective portfolios invested in Amazon. Those large allocations to Amazon meant healthy returns to both funds in the 12-month period ending in July, although neither could keep up with the broader S&P 500.

Until now, XRT’s broad base of retail stocks might have offered investors exposure to the wrong side of the retail trade, but that long list of names could mean the recent double-bottom is signaling the sector is starting to heal. If that is the case, market-cap weighted funds like XLY and RTH with large positions in Amazon could find themselves between a rock and a hard place if investors begin to shift from Amazon to more value-oriented names (see “ETF reversal?”). If that does come to pass, RTH could potentially suffer a double whammy from its concentrated portfolio. With just 26 of the largest names, any rally that involves smaller retailers or specific subsectors could leave investors missing the potential upside while simultaneously being exposed to profit taking in an overextended Amazon.