How To Position As Greed Replaces Fear

| About: SPDR S&P (SPY)
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The S&P 500 (SPY) just posted its best quarter to start a year since 1998. While the 12.6% total return wasn't as robust as Q2-2009, which saw a 15.9% return (or Q3-2009 at 15.6%), it also didn't make up for a miserable previous quarter. This strong move followed an impressive 11.8% rally that finished 2011. We have now posted six consecutive monthly increases.

Here's the $64K question: Is this enough to get individuals to shift their retirement money back into stocks? While early in the quarter there were signs that mutual fund flows were shifting positive, the rest of the quarter saw more of the same: Equity redemptions and billions of dollars flooding the bond market. You can get the most recent data from ICI - it's not pretty. In the first three weeks of March, almost $4 billion came out of domestic equity funds, while over $25 billion poured into bonds.

I have a sneaking suspicion that things are about to change. Imagine, if you will, the conversations that might take place in the coming weeks. Keep in mind that most people aren't like readers of Seeking Alpha - they don't focus on the market every day. They may see the headlines and realize stocks are doing well, but it won't really hit them until they open their quarterly statements. What they will see is that their bond funds, on average, returned 0.3% [based on the Barclay's Aggregate Bond Index (AGG)]. If they look at monthly statements, they will see that they just absorbed their second straight monthly decline. I think that if folks take the time to think about the current state of affairs, they might reconsider what has clearly been an aversion to risk.

Now, before I go on, let me say that I don't blame people for being conservative the past few years. We went through not one but two really terrible bear markets. As we have rallied now for over three years since setting what was clearly generational lows of 666 on the S&P 500, more than doubling, we still remain below the prior peak of 1576 set in 2007. Not only are many investors still seeing their remaining holdings still underwater, though less so, the "flash crash" of 2010 and the high-volatility panic of 2011 surely remain on people's minds. It's well known that we react to pain differently than joy, but the pain is fading. It may take longer to react, but humans, as they tend to be human, will likely chase performance once the trend is clear. I think we are at close to that point. If not now, perhaps when Facebook (FB) prices its IPO in May.

In late October, I shared my forecast for 2012, and it was received generally with skepticism, as I was calling for the S&P 500 to reach 1600 at a time when it was 1285. It didn't help that I made my call right before a nasty November, which took the market as low as 1159 (that was fun!). Well, here we are, five months later, at 1408. I was calling then for a rally of almost 25%, and we have captured the first 10%. While I am sticking to my call, which was basically just a math exercise of multiplying 14 by the projected expected earnings for 2013, let me say that it could end up being a lot higher. I think that 15PE isn't out of the question, and the estimates continue to rise for 2013. Currently, according to Standard & Poor's (registration required), the 2013 bottom-up S&P 500 consensus is almost $119. Doing that math suggests the possibility of 1783 - yowsa! Not my call, but something to keep in mind.

Now, just as when I beat my bullish chest in late October, I realize that nothing goes straight up. In fact, I have been preparing (emotionally!) for what I expect to be a 5-7% retracement in the next few weeks, likely from 1435. Unlike the past two years, when an April peak was followed by a roughly 20% decline, this year's reset should be swift. Why? Because this time there are buyers underneath. Keep in mind that in 2010, the market had rallied sharply for slightly over a year, and profit-taking was natural. Even in 2011, the 5/2 peak of 1371 was over 12% above the 4/26/10 peak of 1220. If I am right about this very near-term peak of 1435, it will be less than 5% above the prior peak. In fact, the Russell 2000 (IWM) is still BELOW its 2011 highs. Bottom-line: Less profits to be taken means less profit-taking!

As I think about how to position for the balance of the year, especially after a pullback that I expect, I don't have a lot different to say from my recent suggestions I shared in "How to Invest in This Bull Market," where I really took more of an ETF approach. I think the main points I made then are still valid:

  • Go Small
  • Go Far
  • Growth is Not a Four-Letter Word (Neither is Value!)
  • Don't Believe the Fed

Specifically, I recommended then and still favoring Small-Cap, Emerging Markets, and Growth stocks, and avoiding bonds. Since then, smaller stocks and emerging markets stocks (VWO) have slightly underperformed, though both are in line with the S&P 500 so far this year.

Today, I want to go beyond what was really top-down strategy that can be implemented with ETFs and share just a few themes that I see emerging that you can play with stocks.

First up is the notion that as investors come back to the markets, they will need help. As I disclosed at the beginning of the year, one of the stocks I have held in both my Top 20 Model Portfolio and Conservative Growth/Balanced Model Portfolio (since late 2010 actually) is Franklin Resources (BEN). There was a nice feature article in Barron's (subscription required) this weekend pointing to its strong positioning. As people shift from cash especially but even bonds into stocks, BEN should benefit. A more interesting idea is Envestnet (ENV), which I added in early March to the Top 20 Model Portfolio, which was up almost 20% in Q1. ENV is a platform for registered investment advisors (RIAs), offering outsourced solutions that offer strong investment products and technology that allows the advisor to focus on servicing clients. I think that this stock should trade to 25PE over the next year, suggesting a potential price of 18 compared with the recent 12.52 close. I haven't looked as closely at the online brokers, but some have custodial relationships with advisors. Both Charles Schwab (SCHW) and TD Ameritrade (AMTD) seem positioned to benefit from a return of the retail investor, who is likely to use an independent advisor in my view.

The other theme is what I call back-door or underappreciated emerging market plays. Most investors want to bet on commodities, like copper or oil, when they consider the prospects for growth in emerging markets. For those investments to work, you have to get both the demand as well as the supply situations down. I prefer to find small companies that I think can provide unique products in these emerging markets. One that I have owned for over a year now in Top 20 is Preformed Line Products (PLPC), which is a provider of infrastructure products. This stock has no Wall Street coverage and trades at less than 10X what I expect it to earn in 2012. In fact, I think the stock could rally from $65.50 to $104 over the next year if can trade to 13PE on the $8 I think it can earn in the 4 quarters ending 3/31/14. Two other companies I follow very closely and that look attractive to me are Middleby (MIDD) and Astec Industries (ASTE). MIDD supplies cooking equipment as well as food processing equipment to a lesser degree. You may be familiar with the aggressive rollouts by Yum (YUM) and Dunkin Donuts (DNKN) in India - well, this is fantastic for MIDD, a strong supplier of both companies. ASTE, historically tied to domestic road construction through its asphalt equipment, has seen its emerging markets business boom. These are just a few examples that come to mind.

So, while the market may be slightly ahead of itself, especially if we get some early follow-through this month, we have most likely reached an inflection point where people start to worry less about the downside and think more about the upside. I have shared a few ways to position one's portfolio previously, and I think focusing on smaller companies, emerging economies, and growth stocks while minimizing exposure to likely rising interest rates makes a lot of sense. Additionally, the return of the retail stock investor bodes well for some mutual funds and to companies aligned with the independent RIA. Finally, I have shared some smaller high-growth companies that have exposure to emerging markets.

Disclosure: Long BEN and ENV in models at Invest By Model