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Retailers Overbought - The Next Opportunity?

A reduction in many household bills and signs of stabilisation in the general economy has created a more optimistic view of UK consumer spending patterns.

… Citigroup believes that for the first time in 2 years the general retail sector looks to have upside potential.

As can be seen from the above chart of the FTSE 100, it has been a cautious and neutral week for the blue chip index.

A set of mixed updates from many of the US banks appears to have stemmed the recent rally. Disappointing results from Bank of America and Morgan Stanley combined with caution over the forthcoming results of the “stress tests” on US financial institutions, has provoked long-standing concerns.

However, there has been a wave of mergers and acquisitions news, which has excited the markets over the last week. Glaxo have bid for Stiefel in a deal worth up to $3.6 billion, Diegeo are eyeing Moet for between £10 - £15 billion, Merck have purchased Schering Plough for $41.1 billion and a range of other deals suggests that companies are starting to see value returning. Such corporate activity is encouraging and could give markets a further boost.

Technical analysis of the above chart shows that the recent upward channel has been breached and the trend that has been in place since early March has been broken. The FTSE failed to post a fresh high and the 100-day exponential moving average (EMA) continued to provide resistance to the index.

The relative strength index (RSI) is drifting lower, which confirms that the recent strength is waning and it would not have been unusual to have seen a sharp pullback by now, so the fact that markets have maintained these gains is extremely positive for the longer term.

In summary, I believe that economic conditions have improved as a result of the substantial measures adopted by various governments. However, I fear that the market has got ahead of itself and the recent technical break down could initiate a move lower in the short term, with important support seen at 3780. Although, further gains through the 100-day EMA at 4107 would invalidate this and suggest that we could see 4300.

The retailers have taken centre stage this week, with the sector average gaining around 10% in the past 7 days. Citigroup released a bullish research note on the sector that initiated the move and better than expected trading updates from Marks & Spencer, Tesco and Debenhams extended the rally.

Citigroup believes that for the first time in 2 years the general retail sector looks to have upside potential. A reduction in many household bills and signs of stabilisation in the general economy has created a more optimistic view of UK consumer spending patterns.

Four years of sharp like for like sales declines has caused many retailers to cut costs and to become as efficient as possible. In turn this has enabled them to increase gross margins, which has been demonstrated by the better than expected results of several retailers this week.

However, retail sales data is yet to show any turnaround, with the Office of National Statistics (ONS) recording that the sales volume in February posted its largest decline since June 2008.

A FTSE 100 listed retailer that has grabbed my attention this week is Next (Epic: NXT), which is the third largest retailer by market capitalisation and provides clothing, furniture and homeware to the higher end of the mass market.

As can be seen from the above chart of Next it has performed extremely well recently, with the shares doubling in the past six months and gaining around 20% in the past few days, which has put them back at levels last seen in 2007.

Next released final results for 2008 on the 26th March 2009, which disappointed the market and was accompanied with a gloomy outlook. Sales were expected to fall throughout the first half of this year, with the weak UK currency continuing to impact the company’s buying power and reducing its retail operating margins.

The retailer is due to update the market with an interim management statement on the 6th May and in light of their previous outlook and the lack of evidence that national retail sales are rising, they may disappoint an extremely optimistic market.

Technical analysis of the above chart is mixed. On one hand, there has been a strong upward trend in place for six months, the moving averages have crossed over and are rising and it has broken through all resistance levels, which implies that the longer-term trend is higher.

However, in the short term I believe that recent enthusiasm has taken the shares too far and this is confirmed by the RSI. The shares have posted a fresh high, while the RSI has moved lower than it was at the previous high and this significant divergence suggests that the momentum behind buying is falling and any selling could cause the shares to quickly pullback.

The rapid increase in the price has put the shares on a full forward valuation of around 12.5x for this year and with earnings not expected to show much growth, a price/earnings to growth ratio (PEG) of around 4.8 looks unattractive.

At the time of writing the share price is 1529p and my short-term opinion is for the shares to move lower. Near term targets are seen at 1439p, 1404p and 1320p, with a stop loss at 1627p.

This report was written by Mark Allen – Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Next. The material in this report has come from Simply Charts and Next’s corporate website.

Quick facts: Next PLC

Price: 6874 GBX

Market: LSE
Market Cap: £9.16 billion

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