Can September’s Rally Continue? How Investors Should Plan for the Months Ahead
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 technical analysis 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.
Even the index fund 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 enterprise value basis — and corporate profit margins remain strong, which is a necessary precursor to an uptick in hiring and capital spending.
Let’s take a closer look at where we stand relative to historical norms.
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 P/E ratio for current year earnings 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 believe that inflation 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 report.
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 sheets. [Read more here]. All that cash is likely my main reason for being a bull 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 yields. As I noted in this piece using Walmart (NYSE: WMT) as an example, the retail giant’s free cash flow yield stands above 5%, nicely higher than equivalent bond yields. A wide range of companies such as ExxonMobil (NYSE: XOM) and Office Depot (NYSE: ODP) 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 economy. 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 economy.
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”. the Fed 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 using the ProShares Ultra Short S&P 500 (NYSE: SDS), 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 for 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 drug stocks.