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Focus on Stocks, Not the Market

By Roger Conrad on October 19, 2012

No doubt about it: The view from 30,000 feet is looking a lot better than just a few months ago.

Exhibit A is the data deluge from China over the past week. China’s gross domestic product (GDP) grew at a 7.4 percent annualized rate in the third quarter of 2012, slightly slower than the previous quarter but well in line with expectations. Meanwhile, Chinese inflation fell to a rate of 1.9 percent, from 2 percent in August.

Other highlights include a rise in September export growth to 9.7 percent from 2.7 percent a month earlier. Industrial output surged by 9.2 percent, up from 8.9 percent. Finally, retail sales growth accelerated to a 14.2 percent rate in September, up from 13.2 percent in August.

The upshot: China should be able to meet the government’s projection of 7.5 percent full-year GDP growth for 2012. And it appears well on track to increase that rate in 2013.

Meanwhile, lower inflation gives the authorities the flexibility to keep money policy loose to ensure growth does meet those parameters. Retail sales are leading the way, demonstrating the country is making progress toward building its own internal markets—and thereby reducing exposure to external shocks.

All this is good news for the global economy. It’s also very positive for China’s main trading partners, including the US, Canada and Australia.

As for the world’s largest economy, the US enjoyed positive economic numbers as well. US homebuilding surged last month, a huge plus since that sector was at the epicenter of the 2008 deflationary market meltdown and has been a heavy drag on growth since. The Philadelphia Federal Reserve Bank’s business activity index ended a string of five months of negative readings with a big jump. Even the US labor market remained on the mend, despite an uptick in weekly unemployment insurance claims.

Last week in this publication, I noted that global investment markets seemed to be leaning in a “risk-on” direction, based in large part on expectations for recovering global growth. This week’s news won’t do much to discourage that more sanguine view, and the impact has already been felt in the financial markets.

Copper prices, considered a harbinger for the broad economy, added to gains they’ve made since mid-summer. Meanwhile, the yield on the benchmark 10-year Treasury note—the beneficiary of every market downturn since 2008—moved over 1.8 percent again, a clear sign of money moving out of this ultimate safe asset.

As for stocks, the S&P 500 Index has been moving steadily higher since early June. We’re still well below the high of 1,576 reached October 11, 2007. But the Index is at its highest level since the 2008 crash, despite some high-profile third quarter earnings misses in the technology sector.

Fourth quarter is usually a good time to be in the stock market, just as late spring through early autumn are often seasonally weak. All else being equal, a decent earnings season and news flow continuing to support the narrative of an improving economy should also spur end-year gains this year.

Unfortunately, while I do expect to see both of those trends, all else really isn’t equal this time around. First, there’s the recession and still tight credit conditions in Europe, which continue to rock asset values both in the euro zone and elsewhere.

As has been the case in recent months, most of the focus this week was on Spain’s efforts to avoid asking for a bailout, and creditor nations’ desire to elude a big hit if it does. Moody’s affirmation of the country’s credit rating after an extensive review is a definite plus, pushing its government bond yields down to their lowest level since spring. So was the successful offer of Italian debt, which saw newly minted 10-year bonds fetch their lowest interest rates in over a year.

As for the common currency itself, the euro has rallied to over USD1.30 this week, after slipping as low as USD1.20 in July. That’s a promising sign that the worst may be behind the euro zone. But as we’ve seen many times in the past several years, there’s still potential for unexpected bad news to raise the fear level again and roil the markets.

Crowd-Pleasing Bellicosity

Elections in the US remain another major source of uncertainty. A key question for resolution on November 6 is which party will have the most seats at the table when Congress and the White House hammer out a deal to avoid the “fiscal cliff.” Investors have a lot at stake in how the two sides decide to ameliorate the economically constrictive package of tax increases and spending cuts agreed to when the debt ceiling was raised in 2011.

Given the cost of doing nothing—mainly a huge hit to economic growth in 2013-14—odds are still good that an agreement will be reached no matter who wins power. That’s still my view, despite the rancor in the most recent presidential debate. Until an agreement is forged, however, there’s potential for a very unwelcome shock to the system.

Then there’s the China bashing in the most recent presidential debate, with the Republican challenger essentially threatening a trade war if elected. Granted, this crowd-pleasing bellicosity is likely nothing more than overheated election season rhetoric. But it’s exceptionally dangerous chatter given the deepening trade and economic co-dependency of the Middle Kingdom and the US, and lingering cross-cultural miscommunications on many issues.

I remain optimistic the world will avoid a catastrophe on these counts. But there’s another problem for stocks that’s considerably more immediate if less acknowledged—valuation.

Mainly, after rising for the better part of four years, stock market averages are again approaching their levels prior to the 2008 crash. In fact, many stocks—particularly higher-yielding fare considered “safe”—have been bid up far beyond pre-crash highs.

That’s part and parcel of what amounts to the triumph of momentum over value in this market. Investors fear a reprise of 2008 as well the possibility of being left out of further market gains. As a result, they bid up stocks that have been rising, and sell off stocks that have been slipping. The question of value or what a stock is really worth is all but ignored.

In an environment like this, it’s pointless to base an investment strategy on the idea that the “stock market” has further gains or losses ahead. Some stocks are far too highly priced now to offer much more potential and they’re vulnerable to the slightest bit of bad news. Others are so cheap, they’ll probably tack on gains even if the market averages roll over.

Times like these are ripe for a strategy that comes down from 30,000 feet to focus on companies here on the ground. We buy stocks selling cheaply that are backed by healthy and growing businesses. We sell companies that are weakening internally, or else have risen to such heights that they can’t help but disappoint.

Earnings season provides an ideal opportunity to assess the internal strengths and weaknesses of the stocks we own. And we’ll be putting all Personal Finance stocks under the microscope—including the recommendations of all Investing Daily advisories—to ensure they’re still solid value propositions.

If the 2008 crash proved anything, it’s that stocks will recover from any debacle, as long as the underlying businesses backing them stay strong. Likewise, the 2009-12 bull market has shown that the market eventually rewards good businesses with higher stock prices.

Focusing on the strengths of what you own—and want to own—is the key to surviving and thriving during the rest of 2012 and beyond. And pointing out the stocks that measure up on strength and value is our primary goal.

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