I have been chewing over our trading expert Mike Turner's
article this week, trying to get a handle on where the stock market
can go from here. [
Read Mike's article here
] Mike points out that September's rally seemingly ignores the
daunting economic hurdles we face. And his
tells us that we may see all of September's gains erased, returning
the major indices to pre-Labor Day doldrums.
I'm inclined to agree. Not only because we haven't seen any really
positive economic news to undergird a rally, but also because
investors have been conditioned to sell into rallies and buy into
pullbacks. That's been a profitable move. If you were a
buy-and-hold investor, you'd likely be seeing only flat returns
since the start of the year.
players are steering clear of buy-and-hold, rotating into different
sectors from month to month. Investors rushed into retail stocks in
February, pushing the sector up by +25% until late April before
fleeing the sector en masse. Airline stocks have been in favor
recently, but who knows how long that will last?
Where we go from here is really a function of whether we view the
current environment as half-empty of half-full. On the one hand,
there is little economic news to cheer and give reason to expect a
more robust outlook in 2011. On the other hand, many stocks are
quite inexpensive -- especially on an
basis -- and corporate profit margins remain strong, which is a
necessary precursor to an
in hiring and capital spending.
Let's take a closer look at where we stand relative to historical
Everything is relative
Depending on who you ask, the stock market's price-to-earnings
(P/E) ratio is either in line or slightly below the historical
average. The S&P 500 stands near 1150, which equals about 16
times projected 2010 profits and about 13.5 times next year's
profits. During the past 75 years, the market's
ratio for current year
has been about 17.
But that number is also associated with interest rates that were
well higher. Recall that in the 1970s, stocks got really, really
cheap precisely because interest rates were so high. This time
around, stocks and bonds are not reacting in tandem. But if you
and interest rates will stay low for a while to come, then the
risk-premium associated with stocks should be reduced, and a target
P/E on the market would be closer to 20. But investors see low
rates as a negative, not a positive. "Equities investors now look
to rising interest rates as a sign of strength and falling rates as
a sign of weakness," wrote Citigroup's Steven Wieting in a recent
In that vein, a modest rise in interest rates may actually be a
positive for the market. In fact, interest rates can rise 300-400
basis points from here and would still be at a level that is
supportive of a rising stock market, historically speaking. The
interest rate discussion is moot in the near-term, as rates are
unlikely to start rising for at least another year. But when they
do, it won't necessarily be a sell signal for the stock market.
But investors aren't buying the stock market -- they are buying
individual stocks and sectors. And in many cases, you'll find P/E
ratios well below the market average, as
I noted recently
Industries with very low P/E ratios include insurance, mortgages,
airplane leasing, pawn shops, dry bulk shipping and companies
operating in China.
And you can find plenty of stocks with incredibly strong balance
Read more here
]. All that cash is likely my main reason for being a
into the first half of 2011, despite the concerns I share with Mike
Turner noted above. Cash fuels mergers, stock buybacks and
dividends, all of which have been key themes any time in the market
is in a mood to rally.
Lastly, it's hard to overstate the relative attractiveness of many
free cash flow
I noted in this piece
as an example, the retail giant's free cash flow
stands above 5%, nicely higher than equivalent
yields. A wide range of companies such as
Office Depot (
have free cash flow yields above 10%.
When bad is good
As noted earlier, the economic picture is pretty dismal right now,
which is likely to lead the Federal Reserve to take action to boost
. The market's recent rally has largely been the result of an
expected round of bond buybacks, which is known as quantitative
easing. As bond sellers like big banks and large enterprises cash
in their holdings, they have more money to apply elsewhere in the
As Citigroup's Wieting recently noted, "vast increases in
precautionary liquidity throughout the economy could also fuel a
more vigorous expansion when 'animal spirits' return." More
specifically, "larger corporate borrowers are likely to
re-leverage, return capital and/or income to share holders and
expand. The small business sector should gradually thaw".
is expected to act by early November.
Action to Take -->
I remain a longer-term bull. But after the September rally,
near-term caution is certainly warranted. I like Mike's call on
ProShares Ultra Short S&P 500ETF (
, which moves at twice the rate in the opposite direction of the
S&P 500. It's nice insurance on your portfolio, especially if
you hold primarily long positions. [Get our trading experts' picks
free each week by clicking here
But if you want to stay fully-exposed to any further market upside,
it makes increasing sense to pick relatively defensive longs. These
are stocks that either have low valuations or can see business hold
up even if the economy slumps further.
Names that come to mind include Walmart, ExxonMobil, and the major
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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