CWS Market Review – January 21, 2011

All good things must come to an end, and Thursday signaled the end of the stock market’s incredible “baby step” rally. For 34-straight trading sessions, the S&P 500 closed above its 10-day moving average. That’s one of the longest such runs on record.

This streak was the result of two factors. The first is obvious: a slow and steady equity rally. The second factor was the market’s dramatic decline in volatility. Wednesday, in fact, marked the S&P 500’s first 1% or more decline in nearly two months.

Over the holidays, the market’s day-to-day volatility seemed to have completely dried up. Put it this way: Prior to Wednesday’s sell-off, the market’s worst day for the year came on January 6th when the S&P 500 lost a measly 0.21%. That’s barely a blip.

I don’t believe the market’s broader rally is terminal, though we may be in for a short-term period of consolidation. Today, however, I want to discuss a more important change in the market and how it affects our Buy List. The big change recently is that the cyclical trade is rapidly coming undone.

Here’s some context: Since the low from March 2009, the S&P 500 has rallied an amazing 89%. That’s one of the greatest rallies in history. Yet as impressive as that’s been, the Morgan Stanley Cyclical Index (^CYC) has rallied 119%. Whenever cyclicals outperform the market it generally means that investors are gaining greater confidence in an economic recovery. “Cyclical stocks” refer to stocks in sectors like heavy industry, autos, chemicals, mining and construction.

Yet for the last seven sessions in a row, the CYC has been badly thrashed by the S&P 500. Actually, that may have been an early warning sign that the market was due for a near-term pullback, and the peak eventually came on Tuesday. It’s interesting to note that the Dow, which is far less cyclical than the S&P 500, was barely dented on Wednesday.

The interesting characteristic of cyclical stocks is that they often (though not always) outperform the market when the market itself is rising, and conversely they underperform when the market is pulling back. In other words, cyclical have a double-whammy effect. So if you’re able to spot the turning points accurately, you can do very well.

So the question now is, “Have cyclical stocks reached the end of their outperformance run?” Right now, I can’t give a definite answer one way or the other. I’m inclined to say “yes” simply because the CYC recently hit an all-time high relative to the S&P 500. My data goes back to 1978 and the ratio reached an all-time high on January 10th.

I’ve also been impressed by the steep discounts we see in many of our healthcare stocks which are classic non-cyclical stocks (people buy Band-aids no matter how well the economy is doing). For example, both Abbott Labs (ABT) and Gilead Sciences (GILD) are going for roughly 10 times this year’s earnings. I just can’t ignore values like that.

Our Buy List is pretty light on cyclicals. I purposely added Ford (F) this year because I wanted to beef up our cyclical exposure. I’m glad I did. Even if cyclicals are headed for a period of lagging, I think Ford will still hold up well. It’s been hit recently during the cyclical pullback, but Ford is still a solid value. The shares are going for just eight times this year’s earnings.

If cyclicals do wind up lagging, our Buy List should strongly outperform the market. Many of our stocks like AFLAC (AFL), Medtronic (MDT), Sysco (SYY) and Wright Express (WXS) will prosper no matter what cyclicals bring. The other indicator that I’m watching is long-term interest rates which often fall when cyclicals underperform. It’s not an iron rule, and with the Fed being so active in the bond market, it may be a moot point.

We’re still early in the first-quarter earnings season. We’ve already had very good earnings from JPMorgan Chase (JPM) which I’m happy to say that I saw coming. After that, however, I don’t see any obvious earnings beats for us. I still think this will be a good earnings season for us, but I don’t see any earnings projections where Wall Street is clearly wrong.

This Tuesday, January 25th, three Buy List healthcare stocks will report: Gilead Sciences (GILD), Johnson & Johnson (JNJ) and Stryker (SYK). Stryker already gave us a preview and we know their report is going to be good. JNJ usually reports very close to what Wall Street expects. Last quarter, they beat by eight cents per share which was about as dramatic as they get. The current consensus on the Street is for $1.03 per share which sounds about right. The company is also currently looking at bidding for Smith & Nephew which makes me nervous since companies often overpay for large acquisitions.

Wall Street expects Gilead to earn 94 cents per share which is probably slightly too low. Even if it’s not, GILD is still an inexpensive stock. The stock is a good buy anytime you see it below $40 per share.

There will probably be some other Buy List earnings reports coming out next week, but the companies haven’t yet said when. Then next two weeks will be a busy time for the Buy List, and we should hear more guidance from our stocks.

The other big news story next week will be President Obama’s State of the Union address on Tuesday. This will be the first time he speaks to the 112th Congress which is partially controlled by the opposition party. There’s also a Fed meeting the next day, and if that’s not enough, we’ll also get our first look at the fourth-quarter GDP report. Some economists on Wall Street are looking for a very strong number, perhaps as high as 4%.

Keep focused on our Buy List stocks. Make sure you’re well diversified, and please don’t be rattled by any near-term increases in volatility. This is to be expected. The key for us is to watch for continued deterioration in cyclicals. If that keeps up, I expect to see more money rotate into the kind of stocks we like.

That’s all for now. I’ll have more market analysis for you in the next issue of CWS Market Review!

Best – Eddy

Posted by on January 21st, 2011 at 7:40 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.