QE3 Can Likely Produce 10% Short-Term Gain

by: David Brown

The Fed has enacted QE3 with an indefinite time deadline. Europe continues to make progress after Draghi's bond buying announcement and Chancellor Merkel's reaffirmation. The market has noticed and responded with a strong upward movement in each of the past two weeks.

But all is not certain. The increasing Middle East turmoil over a very inappropriate video threatens to trigger even more chaos in the troubled region. Assassinating diplomats who probably weren't even aware of the video is a hardly an appropriate response -- yet the anger continues to rise and could spiral out of control. The sell-off in oil prices today seems to belie that point, but perhaps it was a computer glitch (oh no, not another one!). The market hates uncertainty.

The forthcoming domestic election will likely bring even more uncertainty. We can only hope for a functional government after the election.

It is difficult to project a great bull rally at this time. Based on the previous two QEs -- a small sample indeed -- we would guess an upward rally of about 10% to 20% is likely. But to make matters worse, analysts are reducing forward earnings forecasts. While these reductions have not yet outpaced other periods in the past four years when forecasts were cut, they are troubling nonetheless. Sabrient's calculation of valuations still allows for a 10% market rise while maintaining fair value. However, a 20% market rise would cause valuation concerns if earnings forecasts do not resume with at least small increases in the aggregate. Our Sabrient 100 and 300 GARP (Growth at a Reasonable Price) indices still have attractive valuations, but a market higher than 10% could push those positions into overvalued territory.

Here are the market stats.

As for economic data, Industrial Production was down last week, and Empire Manufacturing Index dropped more than expected today. On Friday, we get the Philly Fed. I would say the industrial numbers as well as unemployment drove the Fed action. We will need to wait a month or two to see if industrial output starts moving higher and employment increases.

We recommend hedging with the VIX or ETFs based on it, as the VIX is at historically low levels. Those ETFs offer a fairly small risk at these levels while giving us some downside protection.

4 Stock Ideas For This Market

This week, I used the GARP preset search in MyStockFinder, as a result of last week's strong performance from Small-cap Value (see market stats, linked above). While small-caps have been the best performers, I also included mid-cap stocks as well for more stability.

3SBio Inc. (SSRX) - Healthcare

Cabela's, Inc. (CAB) - Cyclical Consumer

Ameristar Casinos Inc. (ASCA) - Cyclical Consumer

Encore Capital Group Inc. (ECPG) - Financials

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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