The market is at an inflection point. It’s very close to making up its collective mind about the direction of the broader economy. It has reached this stage after a robust contest between two competing visions since spring: one calling for a continued recovery while the other seeing another downturn. But this contest is coming to a head.
My reading of the economic tea leaves gives me plenty of confidence in the near-term growth outlook. Simply put, the U.S. economy has enough strength and momentum at its core to help it overcome the near-term soft patch.
And this is no small matter for investors. The market’s fixation with macro issues, such as the outlook for the U.S. economy and/or the European sovereign debt issue, has resulted in a high level of correlation in stock prices. This means that stocks have been moving up and down in-sync with each other. This type of a market is a stockpicker’s nightmare, as individual stocks don’t move on news about company fundamentals, but about big-picture news flow.
The removal of this dark cloud will bring much needed stability and an overall positive tone to the market. While I am not looking for 2009-type gains, I do expect more appreciation for companies with compelling fundamental stories.
Given the level of recent market volatility, a lot of investors have exited the market altogether. But staying that course is not the best option any more.
I am not only asking you to get back in the game, but recommending a time-tested and disciplined approach to make money in this market. More on that later; but keep in mind that many investors just like you are making a lot of money in this market. And there is no reason why you shouldn’t either.
Avoiding a Fresh Recession
Economic reports from spring onwards, particularly in the summer, started giving credence to the gloomy prognostications of some pundits. While I have all along acknowledged the downside risks to the recovery, recent reports give me much more confidence in assigning very low odds to an outright fresh recessionary downturn. Here are those reasons:
1) Manufacturing Momentum in Place: The manufacturing sector has been at the forefront of this recovery. So it was a major concern when this key growth driver appeared to be losing steam this summer. But recent reports clearly show that while there is some deceleration in the sector’s growth momentum, the summer softness was a temporary pause. We see this in the ISM Index as well as in durable goods reports. A weaker dollar and continued export momentum should also keep the factories humming.
2) Slowly Improving Labor Market: Thursday’s weak Initial Claims report was another reminder of the continuing labor market sluggishness. But while the pace is not to our liking, a recovery is nevertheless underway. The monthly payroll reports have been showing positive private-sector job creations in the last 8 months. And we have started seeing a reversal of the summer’s negative trend in the Initial Claims series, notwithstanding this week’s modestly weak report. Readings of temp hirings, work week and hourly earnings are all pointing in the right direction as well.
3) Solid Corporate Profitability: The corporate sector itself remains in excellent shape, with measures of profitability and financial health as good as ever. We see this in earnings expectations for the second half of 2010 and for 2011. Corporate balance sheets are in excellent shape as well, with multi-year high cash holdings. We are starting to see companies getting comfortable with using their cash piles for investments and M&A activities. Bottom line, this robust profile of the corporate sector is inconsistent with an economy that is on the verge of a major downturn.
4) A Very Supportive Fed: The Fed Funds rate may be at near zero level, but that doesn’t mean the Fed has nothing else in its tool kit. It could use its enormous balance sheet to significantly ease financial conditions. And at its most recent meeting, it reiterated its readiness to do just that if conditions warranted. I don’t think there is need for that at this stage, but having the Fed giving us that assurance is very helpful.
Putting It All Together
With a fresh economic downturn no longer imminent, I expect the market to start rewarding quality stocks. I am not looking for a rising-tide-lifting-all-boats type of rally; it will remain a stockpickers market. But you don’t need to be an investment professional to pick winning stocks.
While such winners have many attributes, three really stand out – Earnings Growth, Quality and Valuation.
- Earnings Growth: Plain vanilla earnings growth is not enough to push stock prices higher, as the market has already factored in those growth expectations. What makes stocks soar is the company’s ability to grow earnings above current expectations. The Zacks Rank helps you capture this key growth potential attribute. At any given time, stocks with a Zacks #1 Rank offer the best earnings growth profiles of the entire market.
- Quality: Quality has its subjective components, but what I am referring to pertains to the quality of the company’s product/service, financial health and management. You want to invest in a company that enjoys a competitive advantage in its product/service market, is in strong financial health and is led by a proven management team. There is nothing subjective about any of these attributes.
- Valuation: If all the positives about a company are already out there in the market, then you may have missed the bus. How can you tell if that is the case? Looking at the company’s valuation multiples, such as price-to-earnings (P/E) or price-to-book (P/B), and comparing those to its peers should give you a good idea of relative valuation.
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Best,
Sheraz Mian
Sheraz is the Director of Research at Zacks Investment Research where he relies on access to valuable data to assess winning stocks and funds. Now, you can gain access to the same research he uses every day for free. Just try Zacks Premium for 30 days at no cost and no obligation.
