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Inventory isn’t just filling up retailers’ warehouses and backrooms right now, it’s also commanding considerable space in investors’ minds—with good reason.

Take

American Eagle Outfitters

(ticker: AEO), which slumped earlier this week following its fiscal second-quarter results: Inventory was up 36% year over year, and the need to clear out that merchandise led to steep discounts that slashed gross margins to less than 31% from more than 42% in the year-ago period.

Barron’s has argued there’s reason to believe in the company’s longer-term outlook, and American Eagle certainly isn’t alone.

Many retailers across the board over-ordered products to avoid the out-of-stock headaches that plagued shoppers during much of the pandemic, amid ongoing supply chain disruption. Yet spiking inflation led consumers to quickly readjust, particularly to the detriment of categories that had proven popular in recent years. Thus, retailers from big box stores to apparel and home goods were left with a glut of merchandise as customers rapidly pulled back from goods they were snapping up just months before.

That led to an industrywide problem. Even savvy retailers that had stocked appropriately felt pressure to sell as over-merchandised stores offered big sales. With margins taking a hit, full-year profit forecasts have shrunk for many companies. Not to mention those concerns come at a time when many investors are already worried about the potential for a demand-driven recession ahead.

The upshot is that inventory is likely to remain top of mind for many investors, and more pain may be ahead, according to DA Davidson analyst Michael Baker.

He parsed inventory data going back a decade, and found that any way you slice it, increases are at decade highs. Total retail inventory is up 22% year over year and up 29% compared with prepandemic levels; things look even worse in apparel, which are up 29% from the year-ago period. “This points to continued and even worsening margin pressure in the third quarter,” he warns.

The problem is exacerbated by the fact that, as noted above, demand has waned even as goods have piled up. Baker’s analysis shows that gap between inventories and sales has widened to a whopping 38%, compared with just 0.2% in the five-year period before the pandemic.

Ultimately he expects that inventories will remain elevated into the fall and even the key holiday shopping season. But if there’s a silver lining it’s at least the “aggressive markdowns being taken right now,” which leads him to believe that we’ve seen the peak of the inventory increases this summer, particularly as retailers have reined in ordering meaningfully.

Of course, as Barron’s noted, casual observers could be forgiven for not realizing the extent of the inventory turmoil, given retail’s strong performance in July and August. With the potential for ongoing margin contraction in the third quarter and concerns about whether there will be too much supply during the crucial holiday shopping season, it’s fair to say that the sector’s rally looks wobbly, and it could give back some gains.

Nonetheless, Baker says that he sees retail stocks and multiples trending upward into the end of the year, as “investors start to look ahead to better margin performance in 2023, cycling a lot of the margin pressures that have occurred this year.”

To that end, his picks are

BJ’s Wholesale Club Holdings

(BJ’s),

O’Reilly Automotive

(ORLY),

Ulta Beauty

(ULTA), with an honorable mention for

Walmart

(WMT).

That said, investors may not necessarily have to agree with his thesis that we’ve already past peak inventory to be more optimistic about these stocks than the rest.

Barron’s has highlighted O’Reilly in the past, and noted that the defensive nature of the auto parts sector in general positions them well at a time of high inflation and economic uncertainty. The group generally enjoys strong pricing power, especially as many Americans are opting to fix their aging vehicles, given that the price of new and used cars has jumped.

Likewise, those worried about a downturn are likely comforted by the beauty industry’s historical resiliency in the face of recessions, a pattern which seems to be playing out again, particularly in Ulta’s robust August results and outlook.

Walmart

was of course one of the best performers during 2008’s brutal bear market, and has publicly said it’s slashed its ordering to get inventory under control, even as its second quarter was better than feared. That hunt for value could also help BJ’s, as consumers grapple with higher costs for food and other essentials, particularly if the industry can raise membership fees.

Write to Teresa Rivas at teresa.rivas@barrons.com