WASHINGTON (Reuters) – Sales at U.S. retailers unexpectedly fell in May for the first time in eight months, but a jump in consumer sentiment to a near 2-1/2 year high in early June tempered fears of a slowing economic recovery. The drop in sales reported by the Commerce Department on Friday reflected weak gasoline prices and the end of a home buyer tax credit that had boosted sales of building materials.

Analysts said the underlying trend of steadily advancing consumer spending was intact — despite some recent data that suggested a slowing of the recovery — and there was little risk of the economy slipping back into recession. “We have placed a double-dip in the U.S. for a long time at 15 percent and that is still where we are. The most likely scenario is the economy continues to grow at a 3-percent pace,” said Michael Strauss, chief economist at Commonfund in Wilton, Connecticut.

Total retail sales dropped 1.2 percent in May after rising 0.6 percent in April. Economists had forecast a May rise of 0.2 percent. Receipts from building materials suppliers tumbled a record 9.3 percent in May after the expiration of incentives to boost the sale of energy-efficient appliances. Gasoline prices, which normally rise in May, fell and weighed on the dollar value of sales.

Core retail sales, which correspond most closely with the consumer spending component of the government’s gross domestic product report, rose 0.1 percent after dropping 0.2 percent in April. “The details for consumption are consistent with a still solid pace, with real consumer spending still on track for around a 3 percent rate of growth in the second quarter, down only modestly from 3.5 percent in the first quarter,” said Jim O’Sullivan, chief economist at MF Global in New York.

CONSUMERS MORE UPBEAT

A surprise pull-back in private business hiring last month put consumer spending under the spotlight and fanned fears the economy’s recovery from the longest and deepest recession since the 1930s was stalling. Consumers, however, are becoming a bit more optimistic despite the recent plunge in share prices. The Thomson Reuters/University of Michigan’s Surveys of Consumers sentiment index rose to 75.5 early this month from 73.6 in May. That was above expectations for 74.5.

“This reinforces the view that what moved sales in May was the unwinding of incentives to buy energy-efficient appliances, and other issues like weather, the price of gas, and so forth,” said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. “If consumers were getting panicked, you’d have expected to see more worry showing up here.”

Stocks on Wall Street initially fell as investors worried weak retail sales could hurt corporate profits, but reversed course after an upbeat revenue forecast from National Semiconductor Corp (NSM.N) signaled a bounce back in demand for the microchip industry. All key U.S. stock indexes ended up for a second straight day. Prices for U.S. government debt rose on the retail sales report, but the dollar firmed against the euro and yen as investors in that asset class focused instead on the improvement in consumer sentiment.

Restoring the economy to health is a key priority for President Barack Obama, and voter anguish over the slow pace of the recovery could inflict heavy losses on the Democratic Party in November’s Congressional elections. Consumer spending accounts for about 70 percent of U.S. economic activity, but with the unemployment rate near 10 percent, households have become more cautious than in previous recoveries.

The Federal Reserve, which has cut benchmark interest rates to near zero to revive the economy, is widely expected reiterate its pledge for ultra-low borrowing costs for an “extended period” when it meets later this month. Chairman Ben Bernanke this week said the economic recovery was on a solid footing, but he remained concerned about jobs.

Last month, motor vehicle and parts receipts fell 1.7 percent, although dealers reported a rise in sales volumes. Excluding autos, sales fell 1.1 percent in May, the largest decline in 14 months, after rising 0.6 percent in April. There were some bright spots, with sales at sporting goods, hobby and book stores rising 0.4 percent in May after falling 1.3 percent in April. Receipts at electronics and appliance stores rose 0.6 percent, reversing the prior month’s fall.

In another report, the Commerce Department said business inventories hit a 10-month high in April, while sales were at their highest level since October 2008. Inventories are a key component of gross domestic product changes over the business cycle and the rebuilding of merchandise stock from record low levels is one of the key drivers of the economy’s recovery.

(Additional reporting by Richard Leong; Editing by Chizu Nomiyama and Padraic Cassidy)

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Three-quarters of the 28 retailers in the Thomson Reuters index beat expectations. Sales could have been even better, but record-setting snow in much of the eastern part of the country curbed gains, retailers said. “We’re going on four or five months here of continuous incremental growth,” said Janet Hoffman, global managing director of Accenture’s Retail practice. “It’s not breakaway spending, but I think that there is enough evidence to tell us that the consumer is happy to be back in the marketplace shopping.”

Even retailers in sectors that have struggled in the past year, like department stores, were able to beat expectations. Macy’s said sales at stores open at least a year increased 3.7 percent in February, and Dillard’s reported a 2 percent rise. Teen apparel retailer Abercrombie & Fitch Co, another long-time laggard, posted a surprise 5 percent increase in same-store sales instead of the 6.9 percent decline analysts on average expected.

“Retailers have really done a great job of limiting their inventories, so they weren’t stuck with a lot of stuff that they had to drastically mark down,” said Ken Perkins, president of Retail Metrics. The Standard & Poor’s Retail Index closed up 1.3 percent on Thursday, its highest level since December 2007, while the S&P 500 was little changed. Since the start of February, the retail index has risen 7.5 percent, outpacing a 2.8 percent gain for the S&P 500.

Top gainers included Abercrombie, whose shares rose 14.6 percent; fellow teen retailer Zumiez, up 10 percent; and Family Dollar Stores Inc, up 8.1 percent after the low-priced chain raised its quarterly earnings forecast. February, typically the slowest sales month of the year, also benefited from weak comparisons with the year-earlier month, when consumers reined in spending during the depth of the recession, shopping only for deeply discounted merchandise. Macy’s same-store sales would have risen 5 percent without the snow, Chief Executive Officer Terry Lundgren said in a statement.

The Thomson Reuters same-store sales index rose 4 percent in February, compared with expectations for a 2.9 percent rise and a year-earlier drop of 4.7 percent. This year’s results were the best for February since 2005, when same-store sales rose 5.7 percent, according to Thomson Reuters. February sales also showed the biggest gain since November 2007, a month before the recession started, said Michael Niemira, chief economist for the International Council of Shopping Centers. ICSC’s same-store sales index rose 3.7 percent in February, and the group forecast a 2.5 percent increase for March.

March sales will benefit from an earlier Easter than last year. But the U.S. economic recovery is still tentative. U.S. consumer confidence sagged to a 10-month low in February amid worries about unemployment and government gridlock, which could also cap any rebound in the retail sector. At the same time, shares of many retailers have had a strong run in the past month and are getting expensive, said Wall Street Strategies analyst Brian Sozzi.

“The discount sector’s stocks still have value, but specialty retailers are coming to the point where they are fully valued – you want to pull back on some of these stocks,” Sozzi said. “The second half of 2010 will be tough because it will be hard to keep improving their gross and operating margins.”

Teen retailers like Abercrombie and Zumiez were a surprise bright spot as younger customers seemed to take to spring fashion. Sales of denim were strong at chains like Buckle Inc and Wet Seal, helping a sector that had been expected to lag. Gap Inc also surprised as same-store sales rose 3 percent, compared with expectations for a 1.8 percent increase.

Lower-priced retailers also fared well, with Target Corp posting a 2.4 percent increase, compared with analysts’ expectations for a 1 percent gain. TJX Cos Inc had a 10 percent rise, beating an 8.9 percent estimate. Family Dollar posted a same-store sales rise of 3.6 percent for the quarter that ended February 28 and said it expected earnings for the period to beat analysts’ estimates.

Snowfall at times shut down cities including Philadelphia, Baltimore and Washington last month. Even in Manhattan, heavy storms on February 10 and February 25 made it difficult to get around. That may have limited traffic in stores, but the higher selling prices lifted sales, analysts said. And the snow missed the three-day weekend that included Valentine’s Day and Presidents Day, key shopping days in February.

Monthly sales data provide a snapshot at certain retailers but are less reliable as a measure of the economy as a whole, since industry leader Wal-Mart Stores Inc and other major companies like Best Buy Co Inc and Amazon.com do not report sales figures each month.

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Many of them saw demand pick up for items that sat out the recession on store shelves, but cautioned investors that they don’t expect a huge improvement in sales trends this year while unemployment remains high. “You are going to see these times where you have consumer explosions, where business will pick up for five or six days, but then they are going to go down again to lower levels,” said Britt Beemer, founder of America’s Research Group, which monitors consumer sentiment.

That raises the competitive stakes for store chains, whose investors are focused on seeing better sales after more than a year of cost-cuts and store closings. “While we still see little meaningful near-term improvement in macro-economic conditions, we do believe there is opportunity to gain market share by increasing same-store sales,” said Macy’s Chief Executive Terry Lundgren.

Lundgren’s view was bolstered by a new survey that showed U.S. consumer confidence fell in February to the lowest in 10 months, as consumers’ short-term outlook for the jobs market worsened, according to the conference board. Macy’s nevertheless said it expects a 1 percent to 2 percent increase in sales at stores open at least a year for the current fiscal year, compared with a 5.3 percent decline last year.

Shares tracked by the Standard & Poor’s Retail Index were off 0.2 percent in afternoon trading. Target slipped 0.8 percent and Sears 1.3 percent, while Macy’s rose 1.3 percent. Home Depot, whose quarterly results suggested continued gains against rival Lowe’s Cos Inc, rose 1.9 percent.

Shopping for more paint

One positive sign is that customers of both Home Depot and Lowe’s were more willing to spend on big-ticket home projects such as painting, new flooring and renovating kitchens after a prolonged slump in the U.S. housing market. Home Depot posted its first quarterly same-store sales rise in nearly four years.

Target has seen customers adding a few more home improvement and apparel items to their baskets, not just buying essentials like food, and expects sales of such discretionary merchandise to improve. “Today, guests are telling us they’re increasingly confident and are visiting more often and shopping more of the store,” Kathee Tesija, Target’s executive vice president of merchandising, said during a conference call with analysts.

But consumer caution was also evident in weekly sales numbers. The ICSC/Goldman Sachs same-store sales index rose 0.9 percent in the week ended February 20, compared with a year earlier. ICSC research forecasts a 2 percent rise in February same-store sales overall.

Macy’s posted fourth-quarter profit of $1.40 per share, excluding onetime items, compared with an average analyst estimate of $1.37 per share, according to Thomson Reuters.

Home Depot posted a profit that beat analysts’ expectations in the quarter, compared with a year-earlier loss. It forecast increases of about 2.5 percent in both total and same-store sales for this fiscal year, while net earnings from continuing operations should rise about 15.5 percent to $1.79 a share.

Sears loses ground to Home depot, Lowe’s

Sears’ profit more than doubled, largely on cost cuts, as its same-store sales still fell 2.5 percent. But the Sears chain appears to be losing market share to Home Depot and Lowe’s, which have invested to improve their stores, said Credit Suisse analyst Gary Balter.

“Would you rather be in the lower multiple names that offer better growth or the higher multiple name that, other than some very effective Internet advertising, operates in stores that have been underinvested in for years?” Balter said in a research note.

Target slightly beat analysts’ estimates as it avoided drastic clearance sales that crimped results in the holiday quarter last year. Sales at stores open at least a year, a key gauge of a retailer’s health, rose 0.6 percent. In the past year, Target reduced inventory and touted low prices to win back consumers who stopped shopping in its stores during the downturn. It is also renovating hundreds of stores to add more fresh food and groceries.

Target said the current Wall Street first-quarter earnings estimate is above its own forecast.

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Net income was $936 million, or $1.24 per share, in the fourth quarter ended January 30, compared with $609 million, or 81 cents per share, a year earlier. Excluding a lower provision for income taxes, earnings were $1.17 per share. Analysts, on average, were expecting earnings of $1.16 per share, according to Thomson Reuters.

Sales rose 3.7 percent to $19.72 billion. Sales at stores open at least a year, a key gauge of a retailer’s health, rose 0.6 percent. Last year, Target’s quarterly profit fell nearly 41 percent as it cut prices to clear holiday merchandise and lost money in its credit card segment as shoppers fell behind on payments.

Since then, Target has reduced inventory and increased its focus on food and pharmacy items to appeal to frugal shoppers. It is also offering to match competitors’ prices. Target’s results come less than a week after larger rival Wal-Mart Stores Inc reported higher quarterly profit, but said sales at its U.S. discount stores fell during the holiday quarter and traffic declined.

Target shares were down 60 cents at $50.04. Wal-Mart shares were down 23 cents at $53.60.

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