Jubak's Journal
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5 steps to help you follow the right trends
Too many stock trends moving in too many directions: That's the problem facing investors today. But here's a way to break through the confusion and create a portfolio that makes sense.
By Jim Jubak
Sometimes an investor would kill to find just one trend driving stock prices. The problem in this market is different, however. Right now, weve got too many trends moving in too many different directions. Investors can find just about any trend and any market direction their hearts desire if they look at the right moment.
So how do you build an equity portfolio when there are so many trends moving in so many different directions?
My suggestion: Build portfolios around just two or three important trends. Make buy and sell decisions for each portfolio independently based on the dynamics of that particular trend. And balance the stock portion of your portfolio to fit your own goals, risk profile and personality by changing the way you allocate capital among these two or three groups of stocks.
Heres how Id go about it.
Identify the trends
First, identify all the important trends in the stock market, and as best as you can, give each one a starting date and a duration.
Very short-term (meaning in the days or weeks until the immediate uncertainty over Iraq is resolved), Id say the trend is down. Stocks will continue to drift lower on very modest volumes. Theres not much conviction behind this trend, but war worries are enough to keep stocks moving lower.
Go out a little longer, though, to take in the next month or so and the trend is likely to reverse with a snap when war or peace breaks out in Iraq. As I argued in my recent column, Believe it or not, this is the war rally, and as my colleague Jon Markman concluded in his piece, Why an invasion wont save this market, the rally is likely to be short-lived. But it will be sharp and profitable. By many technical measures, the stock market has been oversold for weeks and ready for a break to the upside. Positive news about Iraq would be enough to set off this snapback.
But go out a little longer (now were talking about a couple of months), and you can see stocks drifting back into uncertainty as investors wait to see if the second-half economic recovery that theyre counting on actually arrives on schedule and actually delivers some good news on the earnings front.
Some time after that -- say June -- investors will start to get evidence that the recovery will pull into the station roughly on schedule for the September and December quarters. But the growth it unloads will be relatively modest. A second-half recovery will be enough to push stocks back to their December highs of just short of 9,000 on the Dow Jones Industrial Average ($INDU) and just short of 1,500 on the Nasdaq Composite Index ($COMPX). The resulting gains of around 20% on either index certainly would be welcome.
So looking ahead to the second half of the year, stocks would still be stuck in the trading range between the lows of October 2002 and the highs of December 2002 and January 2003.
Looking even further out, expect an economy and stock market dominated by restructuring as individual companies and entire industries reinvent themselves to respond to global cost competition and the rising burdens imposed by retirement benefits. During the first stages of that restructuring, investors might expect something like the 8% annual return that large-company stocks earned from 1977 through 1981, according to Ibbotson Associates. Returns over the second half depend on the success of that restructuring and the direction of interest rates and inflation.
Narrow the number of trends to follow
Second, decide which two or three of these trends are truly major in your estimation and lend themselves to your investing skills and financial goals.
For my purposes, Id narrow the trends down to three: the very near-term bounce from a war rally, the intermediate-term rally from a modest second-half economic recovery and the long-term period of economic restructuring.
Why these three? Because I like the way that the near-, intermediate- and long-term perspectives of the three let me create a laddered equity portfolio. I dont have all my eggs in one time period, so Im not sitting around waiting for the best day to jump on a trend or to jump out. Thats important since I know that I find timing tops and bottoms just about impossible. Working in multiple time periods also lets me be opportunistic about finding stocks that are temporarily depressed in one time frame but that will turn out to be winners in a different, usually longer, time frame.
Match stocks with trends
Third, identify the kinds of stocks that are likely to do well in each trend.
My colleague Jon Markman did a good job of identifying the kinds of stocks that will do well in a short-term war rally. Stocks with the lowest prices generally advance the most in these circumstances, Jon wrote. Take positions in the lowest-priced, cheapest, worst-performing, most heavily shorted stocks in the S&P 500 Index ($INX). If the market goes up 20%, these will probably go up 50% or more as fund managers and others equitize their cash by buying the index. Among the stocks like this in Jons list: AMR Corp. (AMR, news, msgs), Lucent Technologies (LU, news, msgs) and Williams Cos. (WMB, news, msgs).
If you need confirmation that the dogs of the market climb the most in this kind of rally, look at the stocks that scored big gains when the market moved off its October 2002 bottoms. From Oct. 9, the bottom, to Nov. 27, the top, the Nasdaq Composite climbed 34%. PMC-Sierra (PMCS, news, msgs) gained 206%, Continental Airlines (CAL, news, msgs) 160% and Juniper Networks (JNPR, news, msgs) 110%. Looking at the stocks that soared during that October-November 2002 rally can give you other candidates for playing any war rally. And dont forget: the simpler the idea the better. Just because everyone knows airline stocks should rally on positive Iraq news doesnt mean they wont, at least for a while.
A very different kind of stock will do well if the economy shows modest growth, or better, in the second half of 2003. For this trend, dont go looking for cheap stocks that have been crushed. Instead, look for what are called economically sensitive stocks. In this group, Id put mining companies such as Phelps Dodge (PD, news, msgs), Noranda (NRD, news, msgs) and Inco (N, news, msgs); solid-waste disposal companies such as Waste Management (WMI, news, msgs), advertising companies such as Lamar Advertising (LAMR, news, msgs) and even some technology companies.
Stocks for restructuring, the very longest-term trend on my list of three trends, have their own distinctive flavor. Here youre looking for companies that arent simply structured to benefit from a rebound in their sales volume, but ones that also are structured to be low-cost players in their sectors on a global basis. These companies include Dell Computer (DELL, news, msgs), American International Group (AIG, news, msgs) and Sysco (SYY, news, msgs). Companies that dont look like theyll face a need to restructure because they dominate an expanding market include PepsiCo (PEP, news, msgs), whose Frito Lay division is in the enviable position of being able to use its huge marketing clout to expand and spread costs over a growing base.
The challenge for this trend is finding companies that are implementing what will be successful restructurings.
Put each stock pick on a timeline
Fourth, make your buy and sell decisions for each trend portfolio on the timeline appropriate for the trend. In other words, if youre investing -- or speculating -- on a war rally, you want to clear that position after a strong run-up and not hang on to a position to milk an extra percent or two out of the rally. Conversely, if youre in it for the longer term, buy the stocks at what you believe are fair values and then set price targets.
For example, Morningstar has put a $48 fair value on shares of PepsiCo. If your calculations jibe with that, the recent short-term volatility that has driven PepsiCo shares down to $38.90 has created a buying opportunity. If, on the other hand, your calculations result in a fair value closer to the $39 a share figured by Standard & Poors, then youre still waiting for your chance to start building a long-term position at a good price.
Measure your portfolio against each trend
And fifth, measure your current portfolio against the trends youve picked. Do the stocks that you now own make sense given the trends that youve identified, and are they the best stocks that you can find to take advantage of the trends that you see developing?
For example, in Jubaks Picks, Ive built a sizable portfolio to play the possibility of an economic recovery. AOL Time Warner (AOL, news, msgs), JC Penney (JCP, news, msgs), Lamar Advertising and Hughes Supply (HUG, news, msgs) all will do better if the economy rebounds. But the ground has shifted since Ive picked many of those stocks, and its certainly worth comparing the positive leverage on these stocks to those of other candidates. (Ill include that effort in the column I write on looking for high-leverage, economic recovery stocks.)
Now all of this only considers part of your portfolio -- the portion devoted to equities. Ive started there because as confusing as the future may be for stocks, I think its even tougher to figure out what to do with the non-equity portion of your portfolio. The traditional rules and assumptions of asset allocation are now open to question. I dont think its hyperbole to say that asset allocation is going through one of its periodic crises.
Next column: the new rules of asset allocation for the rest of your portfolio.
New developments on past columns
Wall Street 6, investors 0
Were finally getting the fine print on that much publicized $1.5 billion settlement between Wall Street brokerage companies and a group of regulators led by New York State Attorney General Eliot Spitzer. Turns out that only about $450 million of the $1.5 billion total will be characterized as penalties or fines, the Wall Street Journal reports. All the rest will be tax-deductible. So companies like Citigroup (C, news, msgs) and Merrill Lynch (MER, news, msgs) will see their taxes reduced and, in effect, taxpayers will wind up footing the bill for a big part of the settlement. Anybody hoping that the $1.5 billion figure represented enough pain to make Wall Street change its ways is sure to be disappointed at these numbers.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group, AOL Time Warner,Citigroup, Continental Airlines, Hughes Supply, Lamar Advertising, Lucent Technologies and Sysco. He does not own short positions in any stock mentioned in this column.
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