Model Portfolio timbo56:SSOF1

U.S Retailers are being squeezed between rising prices for imported goods and declining disposable income for Americans. This is not a short term trend. By the time the squeeze is over, the stage will be as littered with bodies as it is at the end of "Hamlet." Sears Holdings is terminal, as are the private buyouts: Linens 'n Things, Mervyns, perhaps Toys R Us, and possibly Dollar General. This is a squeeze that will shake retailing to its foundations. Real Estate Investment Trusts that focus on Malls and "Lifestyle Centers" will be pushed to the limit, if not over.

This is all part of a great shift from consumer driven growth to producer driven growth that is necessary for the United States to reduce its huge trade deficit. Until the trade deficit is reduced significantly there will continue to be intense downward pressure on the dollar. The falling dollar will drive up the cost of imported goods, which is a good thing for American manufacturers. It's a huge problem for retailers, however, as they will have a difficult time passing along the price increases. Making the situation even worse is the drop in disposable consumer dollars available to Americans. With food and fuel prices way up and with the possibility of obtaining a home equity loan gone for many, if not most, there is just not the money to spend on other goods that there once was. As the number of disposable consumer dollars shrink, competition for the remaining dollars will grow more intense. Retailers with healthy profit margins in 2007 will see them shrink in 2008. Those who did not have healthy margins in 2007 will be challenged to have any profit at all in 2008.

As an example of how inescapable the coming price increases will be, let us consider a pair of inexpensive gym or tennis shoes, imported from China. First, many of the materials used to make this type of shoe, such as the synthetic rubber of the sole, have their origins in either petroleum or natural gas. Both have risen in price dramatically. Then, the labor of the Chinese workers who assemble these shoes has risen in price in terms of Yuan. Also, the Yuan has risen in value, relative to the dollar. The fuel necessary to move the shoes across the Pacific Ocean has dramatically risen in price, and the fuel needed to truck them to the store has risen in price. Add it all together, and it equals a situation where the store selling those shoes must raise its price.

But the people coming to buy those shoes have had to spend more on gas to get to the store. They have spent more on groceries, just to keep themselves fed. They are going to check the ads carefully and price compare over the Internet. They may buy the next pair of shoes over the Internet, from Amazon.com, yet another challenge to the brick and mortar stores. They will endeavor to drive the hardest bargain possible, because they must. Or they can decide to do without. And that is a real problem for retailers, who must sell, at a profit, to stay in business.

Exacerbating the problem is the heady growth that U.S. retailers, such as Target (TGT), Lowes (LOW) and Kohls (KSS) have experienced over the past 5 years. The growth premiums built into stock prices are not yet altogether gone, although they have certainly been reduced in the last few months. But now the pricing of stocks should reflect a concern for solvency and an awareness that profits may not only be reduced in 2008-2009, but they may give way to losses. It is also difficult to quickly put a brake on the expansion in the numbers of stores. It seems that each company is revising its expansion plans downward, but it won't be enough. Wal-Mart, for example, opened 80 stores in March. Some of them replaced older stores rather than being truly new additions, but that is still a lot of stores. Lowe's and Walgreen's continue their expansions, somewhat slowed, but still at a pretty good clip. Costco appears to be barely slowing its expansion, if at all. Its expansion of market share must come at the expense of some other store or chain. Consumers definitely have a choice, making the potential for price competition so very brutal.

The only chains that may emerge unscathed are the ones that have a large rural connection. This is a huge advantage for Wal-Mart, its roots are rural and it has a huge presence in the southern farm belt, in particular. But chains with a suburban focus, such as Target (TGT), Kohls (KSS) and Home Depot (HD), are going to be tested as never before.

I believe that Sears Holdings (SHLD) is in deep trouble. This is the company that operates both Sears and Kmart, and which is largely owned by entities controlled by Eddie Lampert, the famous hedge fund manager. They have squandered such an incredible amount of goodwill over the last two years, that they meet this downturn very ill prepared. Even now that they are spending on image-building advertising, there is not a consistent effort to present a lively and engaging shopping experience to those who respond to the commercials and venture into a Sears or a Kmart store. Advertising only goes a small way in persuading people to patronize a store chain. Most are likely to patronize a set of stores that they are familiar with. There is a certain efficiency to this, because consumers learn the store layout. They learn where the items they want are located. They have a comfort level with the store that causes them to return. So the goal of advertising should be to convince consumers to just give a store a try. After that, the shopping experience must be positive enough that the shopper will form a habit of patronizing the chain. Unless the stores are fun to shop in, people who respond to the ad, and give a store a chance, won't come back. So the lack of updating of Sears and Kmart stores is slowly deadly. The money saved by foregoing store updating shows up in the balance sheet and the income statement. The loss of goodwill remains unrecognized in the balance sheet and income statement. But in a severe consumer spending downturn like this, that goodwill is needed as never before. I believe Sears Holding is terminal. This downturn will be so terrible that the company will not survive.

I do have puts (a bet that a stock will go down in value) on both Sears Holdings and Target.