A look at the chart to the right - which shows the relationship between Target and Wal-Mart stock - tells a rather interesting story about consumer spending. As the economic recovery in 2003 ensued Targets stock lifted while Wal-Mart stock actually drifted lower. However since the credit crunch showed up on the economic radar Targets stock took a tumble and Wal-Mart stock has caught a bid. Why the disparity? Is it just because Wal-Mart has suffered from bad PR over the years and maybe now folks have finally forgotten about all that?

The Thesis:

While Target and Wal-Mart seem to be very similar - both being big box discount retailers that sell similar products - they have a rather striking difference:

The average Wal-Mart customer earns $35,000 a year, compared with $50,000 at Target and $74,000 at Costco.” [Sebastian Mallaby, Washington Post, “Progressive Wal-Mart. Really,” 11/28/05]

This income difference and the price action in the chart is indicative - and probably obvious to most us who have shopped there - that Wal-Mart sells inferior goods. Inferior goods typically demonstrate a negative income elasticity of demand, which is just fancy economist talk that demand for inferior goods decline as incomes rise. While incomes were rising Wal-Mart suffered as shoppers migrated to the more superior products of Target. But now that the credit crunch has arrived and the economy is weakening consumers are migrating back to the inferior goods of Wal-mart. Keep an eye on these two retailers moving forward as they should tell the story of how the average consumer is doing. In addition this relationship provides a nice pairs trade.

The Trade:

There are several different ways you could play this from a simple long WMT stock and short TGT stock to long WMT and short XLY or RTH. If you want to play this with some options TGT and WMT are in different cycles so you would have to play with JAN 09 LEAPS. If you don’t want to go out that long you can play the September options in XLY and WMT. Stick with At the money strikes on whatever pair you choose. Wal-Mart reports first quarter earnings May 13 so some extra caution may be necessary. Some extra premium is likely bid up in the options which exposes you to extra risk from volatility dropping after earnings. Wal-Mart may report great earnings but it could already be baked in the cake.

As always with bonus trades please exercise discretion and remember that these are for educational and entertainment purposes.