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By Jayson Derrick

The first half of 2013 will continue to be a "tricky" year as all the macroeconomic and market conditions are signaling a continued market run up, but as we have witnessed in the past few years, this can change drastically in a short period of time. Based on all the information today, I believe it is safe to assume that the market will continue full steam ahead at least the first half of 2013. As a day trader and long-term investor I am constantly scanning for these indicators that can be used to evaluate investment and trading ideas.

I often get asked what will be the "catalyst" that weakens the markets and brings out the bears and with that the short sellers who will drive the markets straight down. I believe what typically happens before a retracement is that the risk to reward ratio for stocks becomes unfavorable as the market only becomes positioned for good news. Vulnerability emerges when investors are overweight stocks, valuations are ever more stringent and demanding, and finally credit backdrop is less supportive. I don't believe this is the case, and investors should be allocating any cash sitting on the sidelines to buy equities on any dips. I believe there is still upside for 2013 and beyond, which means that investors can reasonably expect continued growth in their portfolios. I am outlining some of the signs that the S&P 500 and with that the ETF (NYSEARCA:SPY) will continue reaching new all-time highs while stocks will remain "cheap" throughout the foreseeable future.

US economy is gaining momentum

The US economy is gaining momentum despite the fiscal cliff drama as 4-week jobless claims are now at 352.5k which is the lowest level since early 2008. Note the chart below how the US jobless claims have been decreasing steadily for quite some time now.

(click to enlarge)

Source: ycharts.com

Other key macroeconomic factors are continued strengthening in US housing as the IMI index rose in February for the sixth consecutive month to 259, up from 201 in December. The IMI identifies metro areas that have shown improvement from their respective troughs in housing permits, employment and house prices for at least six consecutive months. All 50 states have at least one metro on the list which should solidify the case for a continual improvement in the housing markets. In a January 2013 report, Nasdaq OMX listed the improving IMI index as a catalyst for continued expanding equity prices. The S&P Homebuilders ETF (NYSEARCA:XHB) is up 6.3% since the beginning of 2013, and 12% year over year.

Volatility index is low and staying low

The volatility index, aka the "fear index," fell to a low of 12.46 while the exchange traded note VXX at the time of this writing, is currently trading at new 52-week lows of under $22. Alternatively, the inverse of the VIX which trades under the ticker XIV continues to hit new 52-week highs above the $23 mark.

(click to enlarge)

Source: Yahoo Finance Charts

I can't help but draw parallels to previous market declines. In 2010 the VIX index fell to 15.73 on April 20 just before the April 23 market peak. In 2011, the index fell to 14.69 April 21st, 8 days before the 2011 peak. In 2012, the index fell to 14.47 on March 16, which was two weeks before the April 2 highs. Bulls would be screaming that this is a sign that the market is extremely overbought, however, I would like to point out that the VIX index is simply indicating that the level of fear is at low levels, similar to the sentiment seen in any period prior to 2006 when the VIX was not a sign of a market peak. An equity derivatives strategist at Newedge Group SA shares my views: "Absent another debt ceiling fiasco, the implied volatility as seen in the VIX is falling to better reflect the actual realized volatility environment."

International news: China improving, Europe a concern

More today than ever in our history, global events can have effects within the US markets. With China's outgoing President Hu Jintao signaling that financial reforms will be the top priority for the new leadership, and analysts like Goldman Sachs predicting a Chinese growth of 9% for 2013, China remains relatively stable. When negative Chinese sentiments were announced throughout 2012, investors were scared and took protective measures by buying small caps and moving money out of other venues. A slowing China is the largest threat to emerging markets and the global economy, so investors were taking a "risk off" approach and selecting small-cap companies that do not operate at the international level provide a level of safety. Now that the Chinese economy is expected to grow at a large pace in 2013, investors will seek out large cap companies that will benefit through their Chinese exposure. An analyst at RDM Financial was quoted as saying: "If they continue to produce good growth, that's going to be supportive of our global manufacturers."

Europe remains troubled as the Eurozone fell deeper than expected into recession in the last three months of 2012, as Germany (the most important European economy) contracted by 0.6% which was the worst seen since 2009. With little signs of improvements for the Eurozone, this remains a concern, but not a huge risk to US markets. Love him or hate him CNBC's Jim Cramer stated it best: "Europe is worse than we think, US is better than we think, Asia is far better than we think. So I think things can cancel out to a degree. Do not sell American stocks anymore off of Europe. It's a sucker's game." Many investors would argue against my position that we shouldn't worry about Europe and to that I counter that the market has had at least 3 years already to factor in risk from Europe. The woes in Europe are hardly anything new as investors were fully aware of difficulties from many of the European countries going back several years. For example, on April 23, 2010, Greece officially requested financial support from the euro area countries and the IMF. Many believed that Greece would destroy the entire global markets. Going back in the records, the S&P 500 is up 25% since the Greek crisis took center stage. I believe that the worst news is already priced into equities. A Globe and Mail article makes an interesting point that Europe is so badly beaten that it just can't be beaten any further. I can't help but quote the famous words of Alfred E. Neuman: "What? me worry?"

What to look for in 2013

I like to focus on higher quality and lower valuation investments using the following variables:

  • High free cash flow yield at least 8%. Stocks with high free cash flow have typically outperformed companies with low cash flows.
  • Low EV/EBITDA (below 8.5x). Generally speaking, a lower EV/EBITDA means an investor is spending less money for $1 of earnings.
  • Low P/E (less than 12.5x). A stock trading at a lower P/E is viewed as cheaper relative to a peer that is trading at a higher earnings.

These are the top picks that were extracted from utilizing a market scanner and conducting research.

Name

FCF Yield

EV/EBITDA

P/E

Apple (NASDAQ:AAPL)

10%

7.8

10.2x

CF Industries Holdings (NYSE:CF)

12%

4.0

8.3x

Tesoro Corp. (NYSE:TSO)

20%

2.9

8.8x

Zagg Inc. (NASDAQ:ZAGG)

9%

5.4

8.1x

CA Inc. (NASDAQ:CA)

10%

4.8

10.1X

Apple

This is a no brainer, and I believe Apple trading below $500 is a clear buy. Investors will benefit from (hopefully) more buybacks and dividends in 2013 and beyond. In March 2012, the company announced a repurchase program totaling $10 billion for fiscal 2013. Apple ended the recent quarter with $39.8 billion in cash and marketable securities and generated $61.4 billion in free cash flow over the last year. Apple can at the very least double its buyback program and dividend without any significant damage to the cash balance.

$545 is a reasonable target based on the stock's average multiple from the past two-year period (as of January 23, 2013 when the company reported December 2012 results) of 11.5x to FY14 EPS estimates of $47.55.

CF Industries

As a leading global manufacturer and distributor of nitrogen and phosphate fertilizer products, CF Industries is a great stock that will benefit from favorable agricultural and nitrogen markets. Favorable grain price projections for 2013 will increase the need for fertilizers by farmers. With a dividend yield of ~70bps and an active share repurchase plan where the company already implemented a $1.5 billion share repurchase and it is authorized to buy back an additional $3 billion. Forbes also ranked the company as a top pick for 2013.

Tesoro Corp.

Tesoro is a refiner and marketer of petroleum products, operating seven refineries in the Western United States. The company recently benefited from a few upgrades notably from Bank of America and UBS AG. An article by Bret Jensen makes the clear case to buy and explains that the stock is selling for less than 9x 2014's projected earnings, and earnings estimates for both 2013 and 2014 have been increased.

Zagg Inc.

Zagg is one of the few companies I have ever encountered whose products deliver as advertised. Zagg manufactures protective coverings for consumer electronics and hand held devices. The company has consistently outperformed or matched quarterly earnings estimates for several years now. The beauty of Zagg lies in the fact that they are not taking any sides in the heated cell phone battles. From their website, consumers can buy protective coverings for virtually every product and every brand from BlackBerry (NASDAQ:BBRY), Nokia (NYSE:NOK), and Samsung (OTC:SSNLF). The company has grown tremendously from being a strictly online retailer in 2005 to now selling its products at Wal-Mart (NYSE:WMT) and a licensing and distribution agreement with Logitech (NASDAQ:LOGI).

CA Inc.

Computer Associates International (or CA for short) is one of the largest independent software corporations in the world. Recently, the company exceeded expectations, with an EPS of $0.63 (vs. $0.62) and revenues of $1.195 billion (vs $1.17 billion). CA is in the process of expanding internationally in the Gulf region where demand is particularly high in areas such as project management, service desk and service level management and security. This expansion coupled with a huge dividend yield of ~4% and a revenue and cash flow that has increased for the last four years makes CA a strong buy in my books.

Conclusion

To conclude, I have outlined what I believe to be strong evidence that the markets will continue in an upward trend for at the very least the short term. This does not translate to a "buy anything" strategy, so investors need to pay attention to fundamentals behind the numbers. I do believe that the stocks I have selected are attractive to investors and currently trading at discounts relative to future earnings. I am excited for the coming year and 2013 is already off to an explosive start.

Source: My 2013 Outlook And 5 Stocks To Buy

Additional disclosure: As a day trader I may enter and exit positions in VXX, XIV, AAPL, BBRY for short-term trading but will never hold a position overnight.