While I still remain optimistic about the fragile (but apparent) recovery in the United States, the situation of the global economy is simply too dismal to imply that we've hit the bottom for this year. The stock markets around the world don't always reflect the underlying health of their respective economies, and the United States is no exception.
We saw some monster selloffs in 2011 due to drama in Greece, although it's also true that US data had a hiccup as well. There's no reason to believe that additional drama in Europe (which seems inevitable at this point) won't drive our stocks deep into the red at some point. Since equity/bond/commodity correlations have been tight, I expect stocks around the world to sell off with any dismal news on Europe.
A terrific side-effect of the correlation and computer-based trading is that mathematically calculated "sensitivity" (beta) can drive certain stocks much lower than their peers, even if they are fundamentally unchanged. Until Europe is out of the limelight, I expect trading correlations to be extremely broad. Equities will not get their own little world the trade in - it'll be all about bonds versus stocks.
In the long run, cherry-picked stocks will break their correlations and reach their intrinsic value. The purpose of this article is to narrow down the kind of stocks that one should be looking at if (when) panic hits the stock market again so we can take advantage of the market's inefficiencies.
Checking Past Performance:
Here is a chart which shows the US indices' relative performance in the last 6 months.
And here are the indices since the crash of '09
As you can see the NASDAQ has been outperforming by a small margin, while the Dow 50 has lagged. Then there's performance since the bottom of 2009, where the gap grows bigger - the NASDAQ (QQQ) went up by about 70% while the Dow and S&P went up about 53%. What could be causing this?
I'm sure a lot of it is attributable to Apple (AAPL), which is just absolutely massive (carries a lot of weight on the index) and has rallied nearly 400% since the bottom of 2009 on stellar sales growth of its iPhone and iPad. Still, let's get a better idea of what's going on with US stocks, shall we?
I did a quick comparison of a few of SPDR's sector ETFs to see if industry discrepancies were a major factor in performance.
Included above are materials (XLB), energy (XLE), financials (XLF), tech (XLK), utilities (XLU), and healthcare (XLV). For the sake of sanity, I've left out a few other funds that they offer (like their Biotech ETF).
As you can see, a company's industry has most certainly affected performance significantly in the last ~3 years. Technology is the clear winner according to SPDR's funds, with basic materials and financial stocks not far behind. The defensive industries (healthcare and utilities) appreciated modestly.
The strong domestic growth we've been seeing in consumer electronics (also IT spending) has allowed tech firms to rake it in. Notable examples that I've watched are Intel (INTC) and Apple . Remember that these companies' rallies have not been just based on sentiment - their earnings numbers have been exploding higher.
The outperformance in the financials since the bottom of 2009 is somewhat diminished by the fact that the financial crisis of 2008/2009 drove the big banks down further than most other stocks. Bank of America (BAC) is arguably the best example, especially with the money hemorrhaging out of Countrywide and Merrill Lynch at the time. Its market cap is still a far cry from the pre-countrywide days. I think BAC will rise again, but it will take years (my reasoning can be found here).
Materials performance can be explained in large part by great performance by DuPont (DD), which is weighted as 11.35% of the ETF. DuPont has rallied about 100% since the bottom of 2009. Despite increases in the US money supply, material prices remain tame. This implies that the growth in the materials sector is organic, and not indirectly enhanced by the speculators.
So, now we've looked at one way to pinpoint the best growth stocks on the US exchanges. For fun, I did a little comparison of Vanguard's large (VV), mid (VO), and small-cap (VB) funds to see how company size has been affecting stocks in the last few years.
Based on these ETFs, the larger companies have been lagging in performance. This agrees with the outperformance of the NASDAQ relative to the S&P 500 and Dow Jones Industrial Average. It also seems to fit with the outperformance of the technology industry. Apple, and now Facebook (FB) are two of many innovative technology companies that call NASDAQ their home.
Acting on the info:
There is certainly more research involved in finding diamonds in the rough, but we've made some progress. For ideas, investors may want to start analyzing small-cap technology and materials stocks. There are an innumerable number of small-cap focused articles published here on Seeking Alpha if you are ready to begin your search.
I emphasize research on small-caps, especially now, for a number of reasons. I am still optimistic about companies like the tech behemoth Apple, but so are many other traders. Finding successful tech companies in their early stages is very improbable, but using a shotgun approach will greatly increase your chances.
Why not invest in a technology ETF then? Well, investing in SPDR's tech fund adds heavy exposure to Microsoft (MSFT) and the telecom stocks. These companies offer compelling dividends, but they could very well be past their prime. If we're aiming to create a high-growth portfolio with little to no exposure to Europe, these blue chips don't fit our bill.
Then there's the latest high-profile IPO, Facebook (mentioned earlier), which staged a ~30% decline since its inception. I'm not a social media expert by any means, but Facebook's value looks very questionable for what it is. Weakness in online ad revenue has been putting some weight on Google (GOOG), which brings concern on Facebook's assumed rate of earnings growth.
This is a nagging issue I have with buying large technology companies - there is always a lot of unnecessary bullish hype coming from the media. This sometimes makes analysts who downgrade the stock unpopular people, which could negatively affect prospective shareholders. We'd rather avoid that if possible, right?
Having said that, I also urge investors to check companies' exposure to Europe. Europe's sovereign debt situation is looking quite hopeless despite multiple interventions, so companies that do the vast majority of their business in the United States are preferable. This may be less of a problem with small-caps, since they can be more geographically isolated than their larger peers. Another reason to look away from the larger companies too.
In conclusion, I think it's time to research some fundamentally unaffected small-caps in tech and materials production. If you've got the cash, buy the stocks when the market undergoes an especially traumatic round of capitulation. With a little patience I think one has a very good chance of beating the broader market 2-3 years down the line. I intend on pursuing the idea personally, and I'll be sure to post some companies as I discover them. Stay tuned!