Shares in retailers Tesco (LSE: TSCO) and Morrisons  (LSE: MRW) have started 2016 with a spring in their step. Indeed, year-to-date shares in Morrisons have risen 36% while shares in Tesco are close behind with gains of 28%. This impressive rally has erased most of the losses racked up at the end of last year. 

Over the past 12 months, shares in Morrisons are only down by 0.1% and shares in Tesco are down by 20%, halving the losses from a few months ago. Over the past 12 months, the FTSE 100 is down 10.2% excluding dividends.

But the big question is, are these gains sustainable? The UK retail environment is still extremely competitive. Morrisons and Tesco continue to lose market share to low-cost rivals, profit margins are under pressure and the introduction of the new minimum wage this year will squeeze margins further. 

What’s more, valuations for these supermarkets look stretched. Shares in Tesco are currently trading at a forward P/E of 40.5. Earnings per share are set to grow by 78% next year, according to City forecasts, but even after considering this growth, Tesco’s shares are trading at a 2017 P/E of 22.4. The shares currently support a dividend yield of 0.6%. Morrisons shares currently trade at a forward P/E of 19.3, falling to 17.3 for the year ending 31 January 2018. The shares yield 2.7%.

Improving outlook

The recent gains in Tesco’s share price seem to be driven by the company’s improving trading outlook. The group’s CEO, Dave Lewis recently commented that Tesco was “building momentum” following a better-than-expected Christmas trading period. And customers seem to be returning to the retailer after a huge overhaul in customer service guidelines. According to Tesco’s CEO for the UK and Ireland, Matt Davies, customers are now more positive about Tesco than they have been about the retailer for many years, and this is starting to show through in the sales figures. So, if Tesco can keep the momentum going, the group’s recovery can continue.

Game-changing partnership

Morrisons recently reported that turnover fell 4.1% to £16.1bn in the year to 31 January, and underlying profit fell 26% to £302m. But the key reason investors are now viewing the company in a different light is the game-changing partnership with Amazon. While the exact figures haven’t been disclosed, Morrisons has guided on being able to produce incremental profits of £50m to £100m “from broader business opportunities [that] we have identified within online, manufacturing, wholesale, popular and useful services, and from lower interest costs“.

The bottom line 

Despite the progress being made by both Tesco and Morrisons, structural headwinds continue to weigh on these retailers. Moreover, with the shares trading at such lofty valuations, there’s little room for error if these companies miss expectations going forward. Overall, despite the outlook for retailers improving, it might not be time to buy just yet: there are better opportunities out there. 

Our top analysts here at the Motley Fool have recently discovered one such opportunity. The company in question has already delivered a powerful return for investors over the years, and our analysts believe the company's growth is only just getting started

All is revealed in our brand new free report

Click here to check out the report - it's completely free and comes with no further obligation.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.