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Santa Claus Has Left the Building

By Jim Pearce on December 30, 2016

Given the massive surge in stock prices over the previous seven weeks, it should come as no surprise that this week has not witnessed the traditional “Santa Clause Rally’ that usually pushes share prices higher during the days between Christmas and New Year’s Day. The simplest explanation is that Investors may be tapped out after pumping a lot of money into the stock market since Donald Trump’s improbable victory, driving the major indexes to record highs despite a Fed rate hike and mediocre preliminary holiday sales figures.

We might not see a “January Effect” of higher stock prices during the first week of the New Year for essentially the same reason. Trump’s inauguration in three weeks will coincide with the release of year-end earnings reports from most S&P 500 companies, setting the stage for what could be a volatile couple of weeks. For that reason, many investors may decide to lock in their gains during the first two weeks of January, perhaps setting in motion a rush for the exits.

However, I don’t advise selling your holdings if that happens since neither the recent stock market surge nor its potential swoon can be justified by what evidence we have to go on. By most objective measures the stock market is somewhat overvalued, and ripe for a pullback. But there are no salient data points suggesting our economy is on the downswing, either; in fact, if anything it is gradually improving based on growth in GDP and other traditional yardsticks for measuring economic output.

For that reason, I advise keeping a short list of stocks you would like to own but are currently priced above your buy limits. As one reader of Personal Finance recently asked, “It seems to me that many of your recommendations are ALREADY near their highs. Who wants to buy high?” That’s a fair question, and one that is probably on many investor’s minds these days, which is why I emphasized this point in my reply: “It’s not so much a matter of whether or not a stock is trading at a high price relative to its past value, but if it is priced high relative to its future value.”

As obvious as that sounds, I am constantly surprised by the number of analysts who evaluate stocks based primarily on trailing earnings. While that is useful as a general market indicator, it can be misleading when applied to individual companies. Of course, estimating future earnings is an inexact science that is subject to external factors beyond anyone’s ability to predict, while historical earnings are an empirical fact. But as the old saying goes, it’s better to be approximately right than exactly wrong, and I believe there are still many stocks that can be bought right at fair prices based on their future earnings.

What are they? In this space last week I described three categories of stocks that could outperform the stock market in the near term (“Stock Stocking Stuffers for the New Year”), so today I’ll add another group of stocks to that list; “late bloomers”, which consists of companies that tend to do well in the latter stages of a bull market. They are defined by below-average forward P/E ratios while their net operating cash flow is growing at an accelerating pace.

One way to spot them is to use the S&P 500 Data Table on the Personal Finance website, which scores every stock in the S&P 500 according to Dividend Yield, Cash Flow and Relative Valuation. For the purposes of this exercise you can ignore the first category, and look for companies that earn the maximum score for the other two. To give you an idea of just how overvalued the stock market is at the moment, this morning I counted only thirteen stocks in the entire index that meet this criteria.

I may add one or two of them to the PF Growth Portfolio soon, and I might also use a couple of them in my trading service, Systematic Wealth. But I’m not counting on Santa Claus to deliver merry investment results this week and you shouldn’t, either. Instead, start adding some late bloomers to your portfolio to avoid missing out on the last leg of this bull market.

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