A few weeks back, I asked Jeff Annello to reflect on what he has learned from the rough market we’ve seen of late. With my own hopes for a decent weekend taken out to the woodshed after American Eagle (AEO) got whacked on a combination of a downgrade (market ignored the upgrade pretty well) and news that its merchandising officer would leave the company, I feel the need to be Cramer-esque and sit on my cheap rug, drink a Vitamin Water, and engage in some self-flagellation. Because, bottom line, I blew this call by trying to be a hero and ignore the business cycle. I was several months - and counting, as we still don’t know where the bottom is - early, but in investing, “early” is just a codeword for “wrong.”

There are a lot of things I could say here, and try to tell myself, to soften the blow.
Even though AEO isn’t one of my larger holdings, losing 35% of anything isn’t pretty. And because it’s in a Roth IRA, I can’t even sell the position and take a tax deduction against it.
As I’ve learned from college, tuition payments are only worth it if you take something away with you. Thus, some self-reflection on what went wrong.

-Wrong Industry Within a Sector
In the middle of January, I wrote that retail rallies when you’d normally think it would sell off - primarily as estimates are being cut and the stock is downgraded. This is only partially true; it’s hardline retail that rallies first, and then softline follows later. AEO is a softline (apparel) company, and I should have stuck with Bed Bath & Beyond (BBBY) because it better fit the thesis of retail rallying ahead of a recovery. Consider that BBBY is up 9% since, the S&P 500 is down 4.2%, and AEO is down 29%, and you see just how costly misinterpreting this was.
The thing that really leaves a bad taste is that I knew retail was a hardline story - if you look at the January article, three of the four names I picked were hardline, and those all popped at least 20% after - but somehow I came away with the worst performer of the group.

-The Classic “Buy on Valuation”
When I purchased AEO shares several months back, I thought they were inexpensive relative to the value the brand generates - that is, some reasonable estimate of intrinsic value. Today, of course, the stock is much more inexpensive. Backing out the company’s cash and investments, it sells for about 6x this year’s earnings estimates. While it was more like 9x earnings when I bought shares, it was sold down that much because there would be strong macro headwinds in place for the next several months. Comps aren’t likely to start getting easier to beat until September, and new merchandise isn’t being put in place until halfway through July. In other words, an identifiable catalyst just didn’t exist.
So, as things are wont to do in a tough market, the inexpensive became even more inexpensive because there isn’t a compelling reason to purchase the stock. It’s especially frustrating that American Eagle spent so much on share buybacks last year that (as indicted by my discussion with Judy Meehan), they’ve put further repurchases on hold. If I had known that American Eagle wouldn’t be out buying its own stock, its doubtful that I would have purchased shares myself. By the next earnings report, I’d like to hear that they’ve taken steps to use some of the outstanding repurchase authorization.

-Not Heeding Monthly Comps Enough
I’ve said a couple times that retail stocks have tended to rally on the release of earnings. At face value, this seems kind of unusual, because the earnings reports themselves tend to be pretty bad and the outlooks tend to be gloomy given all the consumer pressures. Maybe with the exception of J. Crew (JCG) a few weeks back, most reactions to retail earnings have been surprisingly positive - but that doesn’t matter. Retailers have been moving up 3-7% on earnings, only to move down 5-15% on the release of monthly comps data. That’s a crummy, asymmetric risk/reward, and with three monthly comps releases for every one earnings report, one that really shouldn’t have been bought with the intention of holding.

What to do now? This isn’t about trying to look good, break even, or anything like that. What really matters is the future - what the stock does from here. Or, to put it another way, would I purchase this stock right now? This is an especially pertinent question because I’ve been raising my cash balance the last several months, and would like to make one or two additional buys. While there are certainly a number of companies on my watchlist that I’m tentatively interested in, American Eagle is still in the top handful, especially at this price. Obviously, I can’t guarantee that AEO won’t get cheaper from here, but I still feel that easier comps a few months out, coupled with an eventual pickup in consumer spending, will result in big margin and bottom-line expansion as well as a rapidly increasing multiple. That’s why, for the time being, I will continue to hold AEO.

Finally, I’m by no means a macro investor, and I should probably try to gain a rudimentary acquaintance with that skill set. To that end, a couple notes on that front that make me cautious on AEO:

-Minyanville’s Todd Harrison made a good argument the other day that the silent threat to the economy is not inflation, but deflation brought about by home equity evaporation and credit destruction. Merrill Lynch notes that $1.2 trillion in home equity was erased in the first quarter of the year, and net home equity extraction fell 60% to just over $200 billion.
I’m concerned about the viability of a number of banks from an investment standpoint (not surety, but profitability), and am really worried about the real inflation/deflation bind we’ve put ourselves in with our fiscal and monetary policies. After all, my generation is probably going to have to pay for it, or at least be very clever at passing along the mess.

-It’s generally a bad idea to own a mid-level (in terms of affluence of clientele) retailer in a declining economic environment. I liked American Eagle partly for their good price/value equation, but it is too much of a liability in difficult times when customers can trade down to Aeropostale (ARO) or something cheaper. I could transpose several other niche examples in here.

-Jim Chanos of Kynikos Associates, the largest investment management firm devoted to short selling, gave a speech last week outlining how the financial media is far too upbeat and focused on positive reinforcement. While I’ve always known this to be true on some level, what does it mean when even the pollyanna-ish reporters are feverishly publishing headlines about the potential for $200+ oil (hat tip Goldman), or a 40% stock market correction (hat tip RBS)?

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Disclosure: I own shares of AEO.