Our Intrepid Outlook For 2013 And 3 Stocks Ahead Of The Curve

by: Stanley Barton

There are dangers in predicting the direction of financial markets. The majority of the analyst forecasts we have reviewed indicate that the bull will continue the stampede in 2013. Few of these seem to account for what we consider to be some of the major influences over the markets in 2011 and 2012, which will undoubtedly come into play this year also. This article is to flesh out our expectations for 2013, and we will provide a few investments that are aligned with that outlook at the conclusion.

The Market Timer's Hall of Fame is an empty room

In August 1982, I published an investment newsletter, Stock Action, and I called, almost to the exact day, the generational bottom to the DJIA at 800. I was too young to know the danger of contrarian predictions, and that lucky call was partly made for the wrong reasons. I have since learned that trying to time the market turns is less productive than identifying correctly the important trends. After we understand the operative trends, we are able set up our portfolios so they react positively once those trends are reflected in stock prices.

Most of the bullish analysts understand the trends monitored by the Federal government: rising home prices and sales, falling unemployment, controlled inflation, low interest rates, modest GDP growth, etc. Conventional wisdom is that these factors are good for the market. In fact, in combination with stock prices at relatively low multiples to earnings, and the lack of alternative investment yields, we could see a "perfect storm" for stock profitability.

For the record, we do think that 2013 will be good for stock investors, but we do have some "walls of worry" that the market will need to climb. The most obvious of these is that rarely is everyone right at the same time. This week the volatility index, sometimes called the "fear index," is at a five-year low, an omen that the market is topping out. One of the major factors that has been influencing the stock market is often overlooked.

The Dollar Dilemma

The predictions for a continuing bull market challenge an important trend that has been in place for the past two years.

The chart above indicates that in 2012 the stock market reacted inversely to the dollar's strength. The boxes indicate that the two largest market declines mirrored spikes in the dollar. Conversely, the arrows indicate that the largest sustained upward move in stock prices was accompanied by a sustained drop in the dollar. Maybe this correlation is coincidental, but we think that any prediction of stock market strength needs to take into account the probable strength of the dollar in 2013.

We are not currency experts, but there are some logical reasons to believe that the dollar will be strong in 2013. Most recognize the dollar as the currency of choice for global payments and safety. We actually think that the accommodative Federal Reserve stimulus is winding down, and the U.S. economy will be rolling under its own momentum. Combine this with the currency easing in Japan, the continued leash on the Chinese currency and the delicate recovery on the European continent, and the dollar is a comparatively desirable global currency.

China specifically will again present more growth and consumption and the strong dollar is not necessarily bad for global stock markets, which may outperform the U.S. markets. These have begun to rebound, but are far from their previous price levels and have room to go higher.

If the strong dollar continues to restrict stock price appreciation, then we think that the market will be choppy and largely sideways. Instead of the powerful sustained rally that other fundamentals may justify, we think this factor will temper the upside, but not kill that momentum.

Bye Bye Bonds

The main reason that the strong dollar will not kill the rally is the huge inflow of money from bonds into stocks that we expect to continue in 2013. Combine that with the timid souls in money markets that will be enticed into the market, and supply and demand forces will keep U.S. stocks afloat.

We must admit that we missed the bond rally. The good news is we did not miss the stock rally. For more on this subject, readers can review our article on Zero Interest Rates, as a primer on why bonds are not a safe haven for risk-averse investors. Bond values drop when interest rates rise, and we only see downside for bonds at essentially zero interest rates.

The Obligatory Political Comment

The best advice we have heard is to turn off the cable news channels. The U.S. political crises are over-hyped, and little factual information is disseminated from these biased "news" outlets. Historically, a president from one party and Congress from another has not been bad for the stock market. We can look at Clinton's second term, and we suspect that an Obama not facing reelection will be able to find the middle ground. The Republican party must find the middle ground for its own survival. We do not want to make light of the fiscal challenges facing the U.S., but these wind out over a period of time, and headline-driven rallies and drops are temporary. The political focus on budget and debt repair will probably be constructive and supportive of a strong dollar theory.

We expect some changes in environmental regulation, tax policy and spending cuts in 2013, but probably not drastic in nature. The tax issue that may gather support is the stock trading tax. This would put a tax of something like 0.25% on stock trades. Actually, we do not think that would be especially burdensome except to slow the computer-generated program trading that has contributed to unwanted aberrations and volatility in the market.

WTI Crude above $82..forever

Energy stocks have not been the darlings in 2012, and few analysts are recommending them as leaders in the expected 2013 rally. We believe that the price of crude oil has little room to drop, and it may be setting up for a breakout.

Technically, the price seems to be consolidating around its current level, and there are more upward forces than downward, in our opinion. We think that factors such as the resumed growth in emerging countries and the U.S., the need for oil producing nations to maintain prices to support inflated sovereign budgets and increasing costs of production will overwhelm the effect of a stronger dollar. We do not think that we will see oil below an $82 technical support level in 2013, and any drops below that will be short-lived. If we live with that assumption, predictions of a $50 rise versus the possibility of a $14 drop seem to favor taking positions in oil-related stocks.

Housing is up...what else is new?

Pretty much all the analysts are ranking housing-related investments in the top sectors for 2013. We think that housing is back and will be growing in 2013, but those companies have a lot of optimism built into their stock prices.

Think about the rules for the old Monopoly game. If I remember correctly, you had to have four houses to develop a hotel on a property. Actually, that concept is not so far from the reality of real estate development. In other words, the boom in housing will create opportunities in 2013 for adjacent retail and commercial development.

How's the weather?

I had an economics professor who once told me that God created stock analysts to make weather forecasters look good. The impact of the weather in the form of hurricanes and droughts has had serious effects on stocks of some companies in 2012. Hurricanes are hard to predict, but droughts are somewhat more predictable with modern satellites and technology. In 2012 the spike in corn, caused mostly by global weather events, interrupted some food processing companies as the rest of the market was taking off.

The above chart compares the price action of Smithfield Foods (NYSE:SFD) with the Grain ETF. It is clear that the high price of grains resulted in poor stock performance of the food processor. This is worth considering as the global need for food is a macro factor that will be important as populations grow.

We notice, in reviewing the futures prices for grains in 2013, that corn and rice futures are selling at double-digit discounts to the current spot prices and wheat and soy are little changed. This would seem to indicate that the food processors will see a reverse in the bad luck of 2012...weather permitting.

On the subject of weather, the effect of Hurricane Isaac lingering in the Gulf played havoc with enterprises in that area in 2012, and some weather luck will make those companies more attractive in 2013.

Conclusion and Selections

The stock market is likely to rise in 2013 due to favorable economic conditions and lack of alternative investments. The rise will not be steady and constant, and the strength of the dollar will moderate the rally and make investments outside of the U.S. more attractive. The U.S. markets will probably experience sideways action for much of the year. In this situation, dividend stocks are good alternatives.

We have seen a boom in housing stocks in 2012, and the real estate revival in retail developments should catch up in 2013. A small cap with a high monthly dividend is Whitestone REIT (NYSEMKT:WSR), which is primarily engaged in acquisitions, development, and management of neighborhood and community shopping centers in Texas, and Arizona. WSR is unique in that it focuses on properties in middle and lower income neighborhoods, frequently with large minority populations. It has a good track record of turning around distressed properties, and there are plenty of available acquisition targets in its market. The housing rebound has started at the top with the luxury market turning first. Logically, the WSR niche neighborhoods were harder hit by recession, and they are later to turn around. This may explain why competitors in the strip mall markets, such as KIMCO (NYSE:KIM) and Federated Realty (NYSE:FRT) have appreciated substantially more than WSR in the past two years.

While those competitors have much larger capitalizations and operate in less risky markets, WSR's superior growth and value measures may make up for those differences:

MARKET CAP 8.44B 6.10B 237M
STOCK PRICE $ 20.70 $ 105.45 $ 14.05
ANNUAL EPS GROWTH 1.2% 6.0% 20.4%
PROJ. EPS - 2013 $ 1.32 $ 4.56 $ 1.25
P/E - 2013 15.7 23.1 11.2
P/SALES 8.67 11.46 5.55
P/BOOK 1.66 5.34 1.39
DIVIDEND YIELD 4.1% 2.8% 8.1%

Specific to 2013, WSR operates primarily in Houston, one of the cities leading the economic recovery with stability of an energy-based economy, which will flourish with stable oil prices. Its next largest market is Phoenix, where WSR picked up cheap properties. Phoenix came late to the real estate rebound, but is outpacing other cities with double-digit housing gains now.

The consensus of analysts is to recommend the industrial, financials, healthcare, housing and technology sectors. Those are logical sectors, and those stocks have not been ignored by the market. We are looking for sectors that have not been so popular, but have not been leaders in 2012. Given our outlook for a strong oil price trend, the energy stocks may do surprisingly well in 2013.

In selecting energy stocks, the shale plays have gotten the most attention. However, one factor to consider is that there is a "groundswell" of concern that fracking is not as safe for aquifers and the geological stability of surrounding communities. This could cause some regulation, delays and added costs to a process that is already costlier than traditional production. We also have seen some surprises in drastic production fall off on completed wells in the oil shale fields. We are wary of the reliability of revenue and resource projections of some of these producers. In 2013, the production gains from these fields may not meet expectations, further supporting the price of oil.

Some of the offshore producers have been quietly accumulating resources, and the market has not given them much love. We think the value of these is more measurable than that of the non-conventional producers. It may be premature, but 2013 may be the year when these become recognized as good stores of value.

Energy XXI (EXXI) has created a portfolio of proven producing wells in the Gulf of Mexico shelf and world-class deep water exploration properties. Bringing horizontal drilling technology to mature wells has upped the production and added available resources. The company has a trailing PE of 10 and revenue growth expectations of 30% for the next fiscal year, according to Yahoo analysts. Of the 16 analysts, 14 rate EXXI a buy or strong buy, with no sells. Despite those positives, EXXI has trailed the market, as have many energy companies, and is near the lower end of its historical price action. It appears to be developing a strong base for appreciation:

EXXI pays a small dividend of less than 1%, but has used cash flow primarily on acquisitions and aggressive debt reduction. The dividend growth should create a more meaningful yield in years to come. What we like is the value of the resources that EXXI controls, given our view of strong oil prices in 2013 and beyond. EXXI has accumulated most of its barrels at less than $20 cost and that is about 30% lower than the industry average. Seasoned management is expected to continue that success story. In 2012, EPS was affected drastically by Hurricane Isaac. A similar event could happen in 2013, but the comps should be positive, especially with some weather luck. EXXI has deferred some gas production, lowering revenue in 2012, but the strategy of adding oil is sound. Currently 70% of production is oil, coming from six of the 11 largest fields in the Gulf. An increase in natural gas prices would be a positive for EXXI that we are not considering.

In the last conference call, management of EXXI commented that the company has adjusted operations according to ongoing regulatory changes. Our view is that new environmental regulations in 2013 in the energy area are likely to focus on other areas than offshore drilling. Recent insider buying in EXXI may be a good omen for the upcoming earnings announcement in a few days.

IQ Global Agribusiness Small Cap ETF (NYSEARCA:CROP) addresses some of our positive target areas for 2013: food production and global markets. The ETF invests in global small-cap companies engaged in the agribusiness sector, including crop production and farming, livestock operations, agricultural supplies and logistics, agricultural machinery, agricultural chemicals and biofuels. There are conflicting dynamics in this group: higher prices for grain producers may equal lower profits for meat producers. This characteristic can moderate spikes, and is more conducive to gradual market movements. Despite this, the ETF has appreciated 15% in the past year.

Our readers who are momentum investors will be happy to see we are not looking at an investment that is scraping the bottom; however, the fundamentals of the holdings in CROP indicate good value:

Ratio CROP
Average Price/Earnings 12.15
Average Price/Book 1.13
Average Price/Sales 0.37
Average Price/Cash Flow 8.44

The holdings can be found here. They include some stocks that have had great appreciation, and some that underperformed. What we like about CROP in 2013 is that many of the holdings are in emerging markets and Japan, which could very well outperform the U.S. markets. Additionally, the weather should not be any worse than 2012, and odds are it will be more favorable for many of these companies.

In summary, we think that stocks in 2013 will yield superior returns than other investments. If the major trends play out the way we expect, investments in the stocks featured here should benefit.

Disclosure: I am long CROP, EXXI, WSR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: We do not know the circumstances, risk tolerance or investment objectives of our readers. There is no guarantee that any investment mentioned in this article will be profitable or appropriate for readers.