Dear Mr. Berko:

I bought Federated, Nordstrom and Costco in late 2004, and now I have good profits in each of them. It looks like 2005 will be a great year for retail stocks, and many of the analysts at the big brokerage firms are recommending the retail stocks. What do you think of the retail industry for 2006, and what stocks would you recommend for me to buy? Do you think I should add to my positions in the three stocks I own that have done so well? It’s exciting to have such good price appreciation, and I hope to make good money if you would give me your best retail stocks for 2006.

B.W., Kankakee, Ill.

Dear B.W.:

Yes, it’s exciting to have good gains in those three issues, and believe me when I tell you that it’s even more exciting to preserve those profits and take them now. Be mindful that a chicken in the coop is worth a dozen eggs in the refrigerator.

The parking lots of Wal-Mart, Kmart, Smart-Mart, PetsMart, Stein-Mart and all the other Marts are packed with people, packages and pickups. Parking spots at malls, downtown shopping areas, discount centers and discount malls are as hard to find as silver needles in a haystack. Manufacturers are experiencing record demand for all manner of toys, clothes, electronics and household goods. Retailers are enjoying record revenues, and consumers are delighted with record low prices, huge merchandise discounts and incredible savings on appliances, designer and fashion clothing, electronic games and gadgets, home accessories, laptops, desktops and handhelds, sweaters, shoes, shirts, socks, furniture and a panoply of other high-demand goods.

Even e-tailers are experiencing an unprecedented growth in retail sales. It’s estimated that e-tailer sales grew by 28 percent in November and December. Many e-tailers are providing consumers with free shipping. The National Retail Federation reports that some 52 million people surfed the Web at work to purchase holiday gifts without leaving their cubicles. The NRF folks believe that holiday e-tail sales will top $21 billion (up from $16 billion in 2004) and that total holiday sales will exceed $441 billion, up from $416 billion in 2004.

In the process, the Dow Jones retail index has taken off like a scalded cat. In November and December, the shares of Costco, Nordstrom and Federated made new highs, while the shares of Wal-Mart, J.C. Penney, Saks, Kohl’s, etc. have had good price appreciation in the past two months.

Investors seem to believe that the economy’s healthy growth (4.3 percent at last report) and the rebound in consumer confidence will trump the awful setbacks caused by Hurricane Katrina, high fuel and natural gas prices, rising mortgage rates and smaller increases in personal income. But investors seem to disregard the potential negative impact that the huge merchandise discounts will have on retailers’ net profit margins offered by retailers to bring the consumer in the door. Though consumers are flocking to retailers in record numbers, they are primarily buying discounted items rather than higher-margin merchandise or normal markup goods.

While changes in mutual fund portfolio holdings for the last quarter won’t be available for a while, I think you might discover that many funds have reduced or eliminated their retail positions. Accordingly, I’d recommend that you lock in those good retail profits and sell Costco, Nordstrom and Federated. Those over-huge discounts offered by many retailers will result in disappointing fourth-quarter and year-end earnings for many of the issues in the Dow Jones retail index, which has handily outperformed the S&P 500 over the past two months.

I’m not sanguine about retail stocks for 2006, because I believe consumers are tapped out and will have much less disposable income in 2006 than they had in 2005. In 2005, a large portion of consumers’ purchasing power derived from home refinancing. That money was used to buy automobiles, vacations, boats, home entertainment centers, furniture, home remodeling and other major items.

Rising rates have already slowed new mortgage activity and will choke those consumers who refinanced with adjustable-rate mortgages, those who got suckered into the low 1 percent or 2 percent over LIBOR rates and those who were inveigled into those “delayed-reaction” mortgages that increase your principal each month. Rising rates will slow new home building, which will slow job growth.

And though I’m bullish on the Dow for 2006 — remember, 2006 is an election year – I’m not bullish on retail stocks, because rising interest rates almost always sound the death knell for the consumer.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net.

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