Investors have been parsing retail sales data for May, but if they want to know the real direction for the group, they’ll need to check out the monthly snapshot of employment trends, which will be released Friday morning. The U.S. economy has begun adding jobs at a meaningful clip in recent months. But if job growth stalls out, it’s hard to envision any upside for retail stocks. (The May job reading should initially seem quite impressive, thanks to massive hiring for the census. But investors will watch for job creation outside of the census. Estimates currently call for 150,000 non-census jobs being created in May).

Far healthier than before

When the economy slumped a few years back, retailers were caught off guard. Inventories and operating expenses were far too high, forcing many retailers to sharply cut back. They eventually did, and that has triggered a solid rebound in profits and working capital. It’s been quite some time since retailers were in such a healthy shape. Gone are the days of massive markdowns to move goods out of the warehouse.

You get a sense of that health by looking at the SPDR Retail ETF (NYSE: PCX), which sharply plunged in late 2008 but now stands right where it was back in 2007, when sales were strong. The key difference between now and then: sales remain stuck at lower levels, but so do inventories and expenses. So profits have rebounded. Trouble is, all the low-hanging fruit has been picked, so for retailers to power earnings higher, they’ll need to see sales rise back toward 2007 levels. If and when that happens, the sector should post record profit levels.

Diverging Fortunes

Against that macro backdrop, individual retailers face varying trends. For example, those that cater to teens are having a tough time as disposable income for the demographic is weak — especially with the paucity of summer jobs available. Only Aeropostale (NYSE: ARO) has been able to pry cash from their purses. Shares are getting a +5% lift today as the retailer announced that same-store sales were modestly higher in May from a year ago, even though the year-ago results were quite robust.

Yet the clouds looming over the entire sector have kept a lid on shares: they still only trade for around 11 times projected fiscal (January) 2011 profits, even as those profits are expected to be more than +20% higher than fiscal 2010 results. Among teenagers, a hot brand can stay that way for some time. In the middle of the last decade, Abercrombie & Fitch (NYSE: ANF) was a teen favorite – and stayed that way for a number of years. Now it’s Aeropostale’s time in the teen spotlight.

Best in Class stay that Way

Amid a month of lackluster sales, it should come as no surprise that Kohl’s (NYSE: KSS) posted another round of impressive comps. The department store retailer has been hitting its sales targets for a seeming eternity, and in the process, taking market share from former industry leaders such as Dillard’s (NYSE: DDS).

A combination of modest same-store sales gains and a small expansion in its store base should enable Kohl’s to boost sales +7% to +10% this year, and profits at a +15% clip. If and when the unemployment rate starts to drop, the stage would be set for continued impressive gains from Kohl’s, which wins more converts from rivals with each passing quarter. Shares trade for a reasonable 14 times projected fiscal (January) 2011 profits. That multiple is likely to expand closer to 20 when job growth is on a sustainable path. That works out to be +35% upside from current levels.

Well-heeled shoppers have returned in force: same store sales at Saks (NYSE: SKS) and privately-held Neiman Marcus both rose +5% in May. Saks recently posted first-quarter profits that were more than double the consensus forecast, thanks to a turnaround in same-store sales, which had been negative for seven straight quarters. The retailer is coming up against fairly weak comparisons from last year, and should continue to post impressive gains as we saw in May. Rising sales are helping Saks to avoid discounting, which is supporting gross margins. They rose 400 basis points from a year ago in the first quarter.

But Saks has more work to do. The company is likely to only reach break-even this year, and may not earn more than $0.25 or $0.30 a share next year. Shares trade for more than 30 times the high end of that range. That profit picture obscures an otherwise very healthy operating outlook. If consumer spending resumes back to 2007 levels, which may not happen before 2012 or 2013, Saks could start to earn $0.50 or even $0.75 a share. In that context, shares appear reasonably priced. But with unemployment remaining at stubbornly high levels, that’s not a bet many are willing to make just yet.

Action to Take –> Shares of a lot of retailers have pulled back in recent weeks, and are unlikely to rally if Friday’s unemployment report indicates a painfully slow job recovery. Yet if we see a strong jobs number, many of these recent laggards could show real leadership once again. If you take a longer view, and want to stick with proven operators that can do well in any economic climate, then you may want to consider Kohl’s and Aeropostale.