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Jubak's Journal
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How to profit in a stuck-in-a-rut market
The market is spinning its wheels as investors decide whether great earnings or rising interest rates will triumph. Here's how to play both sides of this tug of war.
By Jim Jubak
Technical analysts have a very specific term for the listless pattern the stock market is currently exhibiting. They say its range-bound. I say its stuck in a rut. Every up day seems to be balanced by a down day, and stocks just cant seem to get any lasting traction.
The good news is that patterns like these always resolve themselves.
Unfortunately, current indicators are mixed on the outcome. The market could resolve the current pattern by extending the rally that started in March 2003. Or it could be in for a significant correction that completes the downward move that began at the end of February.
My solution for coping with this kind of uncertainty is a strategy that I call "the growth/inflation barbell. It overweights two distinctly different kinds of stocks:
- One half of the portfolio is overweighted with moderately priced earnings-growth stocks. These will do well if economic growth is strong enough to outrun fears of inflation and higher interest rates.
- The portfolio is also overweighted with a group of what Id call inflation stocks. These will do well if commodity prices continue to rise, the dollar continues to weaken and worries grow that the Federal Reserve will raise interest rates.
Because of the very different volatility of the stocks in these two groups, investors who carefully control their risk can make money on a strategy like this -- even if the stock market remains range-bound or shows further signs of correcting.
Today, Ill explain the macroeconomic underpinnings of the growth/inflation barbell strategy. In Tuesdays column, Ill give you some guidelines for designing this kind of a portfolio and some specific picks you can use to implement the strategy.
A war between earnings and interest rates
Stocks are currently in one of those periods where its almost impossible to establish a strong trend. Whatever good news we get is kept in check by bad news.
Favorable news about the economy encourages investors to hope for better-than-forecast company earnings. But that good news also raises fears that stronger economic growth will force the Fed to raise interest rates sooner rather than later. So any rally is limited.
Bad news about the economy raises fears that corporate earnings will disappoint, but the news also postpones the day when the Fed will take away the low interest rates that prop up current stock valuations. So any retreat is limited.
The action on Monday and Tuesday (April 12 and 13) were perfect examples. On Monday, stocks rallied as investors who had sold shares before the long Easter weekend bought back into the market. The Dow Jones industrials ($INDU) climbed 74 points, and the Nasdaq Composite ($COMPX) jumped 13 points.
Related news and commentary on MSN Money
On Tuesday, stocks couldnt follow through. When the government announced that retail sales in March grew a higher-than-expected 1.8%, economists pushed their estimates for first-quarter U.S. Gross Domestic Product growth up from 4% toward 5%. And then the traders speculated the Fed would raise interest rates a quarter of a percentage point this summer and maybe a half percentage point before the end of the year. The Dow tumbled 134 points; the Nasdaq fell 35 points.
In other words, theres a war going on now with stocks between earnings and interest rates.
If stocks can deliver earnings above Wall Streets and investors already high expectations, stock prices should move higher. That assumes, however, that the Feds overnight interest rate remains at the current 48-year low of 1%. Data ranging from Marchs 1.8% increase in retail sales to better-than-anticipated first-quarter earnings suggest stronger earnings growth is a real possibility. First Call says this earnings season is on track for 20% to 21% growth compared with a year ago. Thats considerably ahead of the 17% earnings growth that Wall Street had projected at the start of the quarter.
Of course, you can find evidence of danger in that kind of earnings growth in future quarters. Oil prices of $37 to $38 a barrel are forcing companies to make huge adjustments to protect profits. Chemical giant DuPont (DD, news, msgs) recently cut 3,500 jobs, mostly in the United States, to make up for rising natural gas costs. At some point, the cost-cutting cant keep up with the energy bills; they will start to eat into corporate profits.
Right now, it certainly looks like earnings growth, though better than expected in the first quarter of 2004, peaked at 26% in last years fourth quarter. Wall Street now projects 15% earnings growth for the second quarter, 12% for the third, 13% for the fourth. And then 12% for all of 2005.
But the key remains interest rates: Stocks are trading at valuations so high that only the current extremely low interest rates make those prices justifiable. Heres how stretched valuations are:
Intel (INTC, news, msgs) announced Tuesday that first-quarter revenue climbed 20% from the first quarter of 2003 and earnings per share soared 86%. A fine quarter, but the news proved basically neutral for the stock. Reason: Even after that 86% earnings jump, Intel is still selling at 29 times trailing 12-month earnings per share.
Even small rate increases can cause problems
Let me show why interest rates are so important now. Well work with what many analysts call the Federal Reserve valuation model. Strategist gave the model its nickname because they believe the central bankers use it to figure out the fair value of the stock market.
Stock-market history shows a reasonable correlation between the forward price-to-earnings ratio of the 500 stocks that make up the Standard & Poors Index and the reciprocal of the yield on the 10-year U.S. Treasury note. So, if the 10-year note is yielding 5%, the forward P/E on the S&P 500 would be 20.
Now, lets go to real life. Right now, First Call calculates the forward price-to-earnings ratio (second-quarter 2004 through first-quarter 2005 projected earnings), normalized for the business cycle, at 18.3. The April 13 closing yield on the 10-year Treasury was 4.35%. The reciprocal of that -- 100 divided by 4.35 -- is 23. So using this formula, which even its supporters say gives misleadingly high fair valuations when interest rates are extremely low, the current market is undervalued.
Of course, it was even more undervalued on Monday, when the 10-year yield was just 4.23%. So, Tuesdays move to 4.35% was enough to reduce the fair value of stocks by about 2.75%.
So, what would eliminate this undervaluation of stocks? Just boost the 10-year yield to 5.46% -- a level last seen in May 2001.
In other words, if the yield on the 10-year rises just one percentage point, stock prices theoretically should go down -- even if the companies produce all the earnings growth Wall Street is now counting on for the next four quarters.
See why even the thought of the Fed raising short-term interest rates by 75 basis points (0.75%) by the end of 2004 is enough to put a knot in many investors shorts?
What could make the Fed raise rates?- A huge increase in the rate at which the economy is adding jobs. March showed a jump in nonfarm payrolls of 308,000. That brings the total increase to 760,000 since August. Finally, the economy is producing a significant number of new jobs. But this isnt the kind of huge number that would panic the Fed into slamming on the interest rate brakes. The Fed has said it will have to see a few months of this kind of growth before it is willing to raise rates. I dont see any reason to suddenly doubt that policy statement. The most likely scenario is still a modest first hike no earlier than late summer and possibly not until late fall.
- Evidence of runaway inflation. Core inflation -- thats the Consumer Price Index minus volatile items such as energy and food -- is inching upward. But that inching is from the 40-year-low of 1.1% in November through January that kept the Fed in a dither about inflation. The March core CPI climbed 1.6% year over year. Thats the kind of healthy inflation the Fed would like to see more of. There is lots and lots of anecdotal evidence that companies are starting to raise prices. Procter & Gamble (PG, news, msgs) and Kimberly-Clark (KMB, news, msgs) have announced that theyll raise prices on paper products such as Bounty paper towels and Kleenex tissues for the first time since 2000 effective this summer. Those increases, however, are likely to be slow to work through the system at the consumer level. The inflation picture, too, argues for a late-summer to late-fall initial interest rate increase.
No longer a question of if but when
But notice that the argument is not about whether the Fed will raise interest rates but when -- and at what pace. That pretty much guarantees that, over the next six months, investors in the bond and stock markets will move in anticipation of the inevitable. Its already started, in fact. Bond traders have pushed the 10-year yield up from 3.68% on March 17. And so far this month, stock investors have been fleeing income vehicles such as real estate investment trusts.
All this argues, I think, for a market that continues to vacillate. It will fall on days when investors see higher rates coming very soon. It will rally on days when investors become confident that the rate increases will come later and will be relatively modest and on days when they believe earnings will grow fast enough to more than keep pace with any interest rate increases.
Next up: The micro details on what such a portfolio might look like, what to weed out of your current stock holdings and some picks for implementing this strategy.
Changes to Jubak's Picks
Sell HCA
It was a good idea: Buy the troubled hospital company on evidence of a turnaround. It just hasnt worked out, and its time to pull the plug.
To use a highly technical investing term, the fundamentals of the hospital business stink. Theyre even worse than I thought when I added this stock to Jubaks Picks on Sept. 5, 2003. On April 14, HCA (HCA, news, msgs) warned investors that earnings for the first quarter and for all of 2004 would fall below expectations.
The reason is pretty simple: Specialized hospitals and clinics are siphoning off the patients best able to pay their medical bills, leaving HCA and other general hospital operators with more than their shares of uninsured and underinsured patients who wont be able to pay their bills. The company announced that, for the first quarter, it was increasing reserves for bills it expects to remain unpaid to $694 million. Thats up 62% from the $428 million it reserved in the first quarter of 2003. Short of a quick solution to the health-care crisis in this country, I dont see a quick resolution to this industrywide problem. And Im not expecting a quick solution. Im selling these shares with a 6.3% gain since I added them to Jubaks Picks at $37.05 in September 2003.
New developments on past columns
5 big-picture reasons to snap up energy stocks
On April 9, the International Energy Agency, the energy watchdog for the 30 nations in the Organization of Economic Cooperation and Development (OECD), raised its forecast for global oil consumption yet again. For the April-June quarter, the agency projected that global demand would average 78.3 million barrels. Thats 273,000 barrels above the last monthly forecast and a total of 2.24 million barrels a day higher than the agencys forecast for the period a year ago.
So much for fears of a spring slump in demand.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the owned equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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