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Check out this week's Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com

Where's the Economy Going?

I am putting perma-bears and bubble alarmists in the Danger Zone this week. I am optimistic about the U.S. economy and I don't believe we are in bubble. Too many investors and economists are looking at the economy the wrong way. They see slow growth in GDP and employment and assume these are bad for the health of our economy. They look at the S&P 500 surging upwards and say it is caused by the easy money policies of the Fed, not the underlying profitability of these companies.

My response to these arguments is that slow growth can be better for the long-term health of an economy than rapid growth. Just look at the last couple of bubbles. GDP grew by nearly 5% a year and unemployment was at 4% in the late 90's, and we all know how that turned out.

Rapid growth is not always healthy for an economy in the long-term, while more measured growth can be an indication that resources are being allocated more efficiently. I believe what we're seeing now is the allocation of both human capital and business capital becoming more efficient.

The slow level of employment growth is not a sign of a stagnant economy. It is the result of significant transition as people are learning new skills to suit more productive jobs. The jobs that were lost when the last bubble burst are not the same ones coming back, and that is a good thing.

Much has been made of robots displacing low wage workers as companies seek more cost efficient solutions. Short-term thinkers decry the negative effect this has on employment, a valid concern. However, they ignore the fact that in the long-term, the mechanization of these jobs will free human capital for more productive work. There will continue to be enough jobs that humans perform better than machines, it just takes some time in the new economy to identify these jobs and train workers for them.

Already the signs are there that human capital is being used more efficiently. Corporate profits are near record highs even with a significant portion of the labor force not being utilized. Retraining the labor force is painful in the short-term, but it gives us a significant competitive advantage in the future.

Businesses are also allocating their monetary capital more deliberately. Companies are less and less putting significant money into low return on invested capital (ROIC) projects. The rapid pace of disruptive innovation means practices from even just a few years ago are already outdated in many industries, and corporations need to consider the impact of technological changes before investing significant capital in a project.

What Does This Mean for Investors?

Analysts keep debating whether or not the market is overvalued, but I think they're making a fundamental mistake in treating the market as a homogeneous entity. I don't expect stocks to crash or spiral up in the future. Instead, I see significant market corrections, in both directions, coming for specific stocks. We have passed the point where momentum and theme strategies work. Now is the time to get back to real diligence and identifying those companies with over and under-valued stock prices.

In my last two Danger Zones I identified two stocks that are in line for significant downward market corrections: Apple (AAPL) and Amazon (AMZN). Both these companies have been run up on market hype, but they'll have a tough time bringing in enough profits to justify their valuation. Apple and Amazon have been great innovators, but consumers, rather than shareholders, will benefit the most from their innovations going forward.

Citigroup (C) is another example of a stock that is in line for a significant correction. With the stock up 34% year-to-date and 100% over the past 12 months, Citi investors are partying like its 1999-literally, as the current valuation implies the company's margins will return to its late 90's/early 2000's highs around 20%. In today's regulatory environment, I just don't see that happening. Even if Citigroup can maintain the huge margin increase it achieved in 2012 (from 1.4% to 13.7%), it still would need to grow after-tax profit (NOPAT) by nearly 12% compounded annually for 15 years to justify its current stock price of ~$53.27. The stock's valuation is writing checks the company can't cash.

On the other hand, there are many companies out there that remain undervalued. Two of my favorites are International Business Machines (IBM) and Oracle (ORCL). Oracle is a great example of a business growing more efficient in its use of capital. From 2004 to 2008, Oracle increased its invested capital from $530 million to $28.4 billion, trying to fuel growth through major acquisitions. However, profits grew much more slowly, and Oracle's ROIC declined from nearly 400% in 2004 down to 23.5% in 2008. Since 2008, however, Oracle has been much more careful and efficient, increasing its invested capital by only 30% while nearly doubling NOPAT to raise its ROIC up to 32%.

Similar to Oracle, IBM has a U-shaped ROIC curve over the past decade or so, bottoming out near 9% in 2005 before coming back up to around 16% for the last two years. Both Oracle and IBM are positioned to play important roles in our future economy. Oracle's database systems and IBM's cognitive computing have huge potential as our economy becomes more and more data driven. However, the valuations of these stocks do not give the companies any credit for future profit growth. Oracle and IBM, with valuations of ~$34.34/share and ~$209.36/share respectively, both have a price to economic book value ratio of 1, implying that neither company will ever grow NOPAT beyond its current level. I expect the valuation of these companies to correct upward as the market starts to recognize their true profitability.

Investors looking to coast to easy profits in a bull market or short a bear market are out of luck. Overall, the market will be bumpy, and outperformance will depend on picking the best stocks based on fundamentals. There is no substitute for due diligence, a lesson I expect investors will learn all too well in the near future.

Sam McBride contributed to this report.

Source: Danger Zone 6/4/2013: Perma-Bears And Bubble Alarmists