When Tiffany TIF reports second-quarter results Friday, we expect it to maintain robust sales and margin momentum, fueled in large part by continued strength of higher-quality diamond prices as well as strong tourist sales in major cities. But eventually, positive price spread tailwinds will reverse. While Tiffany has benefited in the short term and we view its economic moat as stable, we also believe the stock could suffer as the tailwinds subside. At the same time, if there is diamond price relief, the headwinds that we've pointed out at Blue Nile NILE could abate.

Diamond prices have been rising quickly for more than a year, but now with an equity market correction to digest, some dealers are taking pause or even suggesting prices will now retreat. In the short term, rising prices are actually good for high-end retailers such as Tiffany, Cartier (a division of Richemont), DeBeers, and Bulgari (a division of LVMH). High-end retailers and jewelry creators hold inventory that rises in value as spot prices rise. Tiffany has supply contracts and--thanks to its strong brand equity--the ability to raise prices. With strong foresight, management has built a good deal of supply diversification to prevent the brand from getting squeezed. It even had interests in a mine and is a Diamond Trading Company (DeBeers) contract dealer. Given the price rises this spring and summer, global demand has risen ahead of supply and we'd expect Tiffany's small rough diamond wholesale business to show positive improvement in its upcoming earnings report.

When prices rise, existing inventory is worth more when sold at retail, contributing to gross margin increases. Tiffany and Richemont have about 12 and 18 months of inventory, respectively. Blue Nile has the opposite problem: It pays for inventory in real time and has no working capital. If prices go up, Blue Nile must pass that rise on immediately to the customer. As Blue Nile is among the low-price leaders (catering to more price-sensitive customers) and already has thin operating margins, a small decrease in gross margins can result in a big dent in profits. In addition, research by PriceScope on diamond prices suggests that prices for mid- to low-end diamonds, around 0.5-1.0 carat weight, have risen 26% while most other sizes have risen 16%-19% from January through July. The price sensitivity of the lower end of the spectrum, where Blue Nile sells the greatest number of engagement rings, is behaving more like the cotton apparel market than the gift-giving market for Tiffany and Cartier.

Historically, luxury goods prices have been correlated to other commodities. Wine, like gold, has a correlation to oil, some research has suggested. Yet, in our experience, consumers' reaction at the high end is opposite that of the low end: Low-end, commoditylike goods suffer softer demand as prices rise since consumers cut back, substitute, delay purchases, or make investments to change consumption patterns. High-end goods, especially precious metals and gemstones or even ultra-high-end watches, in our view, become more coveted and are even hoarded as prices rise. These "durable" items seem like a good deal as prices are rising if consumers believe they are an efficient store of value. Our research suggests that in the short term, this is true, and that significant jewelry and watch brands, sold by companies such as Tiffany, Cartier, or Piaget, actually do have efficient secondary markets in which prices of previously owned goods rise and fall dependent on the price of the new goods in the market. A diamond ring from Tiffany can be resold on eBay EBAY and even receives a premium if it can be proved to be genuine; a cotton T-shirt from J.C. Penney JCP cannot.

Now, as commodity prices have perhaps cracked, many industry observers are wondering if diamond prices will finally decline. At least during the weeks of the rocky equity markets, prices have stabilized or even softened slightly in some markets. But as diamond industry guru Rapaport is preparing to launch an institutional diamond investment fund (a sign of a bubble, in our view), we point out that there are two characteristics of diamonds that make them very different than any other commodity: They are small, and they never wear out. This makes them easier to hoard, and because they haven?t been consumed or altered (melted, worn, or damaged), stones can easily be added back to the supply equation. This happened in the 1980s the last time diamond prices were very high, which also corresponded with very high gold and oil prices, a situation that rhymes with the present. Richemont chairman Johann Rupert said recently that the same thing becomes true with watches if dealers believe prices will rise on a regular basis; they order more inventory than they are selling in the hope they can sell later into a higher-price market.

The management teams at Tiffany and Richemont are prudent and mindful of these problems. Companies with 100-year-old brands tend to raise prices very carefully, sometimes more slowly that the raw goods markets; they want to manage the brand in an orderly fashion so as not to create panic or devalue the brand as prices rise or fall rapidly. We advise investors to buy these stocks when prospects look dim and to be careful when it appears prices are sure to keep climbing. Richemont, although trading near our fair value estimate, is cheap relative to Tiffany right now, as it has costs in Swiss francs. We may find both franc and diamond holders eager to sell if the market becomes convinced prices will decline. Blue Nile is a stock we've loved to hate of late, but it is now trading well below our fair value estimate and eventually should see a pickup in the price-sensitive customer.