Wall Street Reveals Top Holiday Picks

The battle for consumer dollars this season may be more intense than usual, with high gas prices and a general economic slowdown pointing to a deceleration from the rate of spending growth in 2005.

The dismal news comes in a recent report from Forbes, as Wall Street does its best to handicap the upcoming battle, presenting investors with their best and worst bets on department stores, electronics sellers and specialty stores.

Merrill Lynch is already predicting a lackluster season for big discounters Wal-Mart Stores and Target, whose shear size makes it difficult to drive year-over-year sales.

Indeed, the season appears to be kicking off early, as Wal-Mart says its same-store sales for October grew by just 0.5 percent, the company's most anemic monthly growth rate since 2000. This comes as a government report Monday morning shows that consumers kept a firm grip on their wallets in September, boosting spending by just 0.1 percent, the smallest increase in 10 months.

The National Retail Federation is projecting 5 percent growth in holiday spending this year. That's reasonably healthy, thanks largely to the strong job market, but it would fall below last year's 6.1 percent pace. Industry consultant Adam Levin believes that because high gas prices have worked their way into the economy over the past months, they figure to have more of a negative effect on spending than they did a year ago.

Analysts, though, are more interested in how the season will break down between winners and losers. According to Merrill's annual holiday forecast, low-end dollar stores (up 8 percent) and high-end luxury merchants (up 7.2 percent) are predicted to lead the pack in the November-December 2006 period. Big department stores and specialty clothiers, both expected to increase sales about 4 percent, will lag behind. But even specialty stores are on track for solid profits in the fourth quarter despite slowing sales growth, according to Lorriane Maikis, who covers the sector for Merrill Lynch.

"Inventories are extremely lean, and employee costs are down," says Maikis, who predicts 17 percent earnings growth for specialty retailers.

Strong margin potential should buoy some large department stores as well, even in what's shaping up to be an average overall season. Richard Hastings, a retail economist at Bernard Sands, highlights J.C. Penney and Kohl's as two stores with enough margin flexibility to avoid being very negatively affected by price promotions, should they be needed to draw traffic.

Merrill's Stacy Turnof, who covers department and dollar stores, projects a 13 percent earnings increase for J.C. Penney for the fourth quarter, above consensus estimates. She's a fan of the company's "Red Box" holiday campaign, for which it's putting a large advertising budget behind 20 to 30 items. And at 14 times earnings, Penney's stock offers a pretty attractive valuation relative to the average industry multiple of 16 times earnings.

Turnof also recommends shares of Federated Department Stores, which picked up a superior gift strategy company in May Department Stores that will positively affect the company's Macy's unit, and Nordstrom, a luxury store largely insulated against cyclical downturns that has improved its women's line. Turnof projects fourth-quarter earnings increases of 13 percent at Federated and 22 percent at Nordstrom.