How to Play This Flat Market

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club
Man talking on the phone

More than a few investors are scratching their heads over the Dow's performance so far in 2014.

It stumbled out of the gate in January and February, then rallied from March through mid-April, then gave up the ghost in early May and has been bumping up and down ever since as investors swing back and forth from anxiety to complacency.

What's going on here, and how do you play it?

As for what's going on, that's an easy one. Over the last five years, large stocks have more than doubled. Small stocks have more than tripled. This kind of performance begs for a period of consolidation where short-term traders can lock in profits and test the waters before committing serious capital again. This is a normal and natural part of stock market behavior.

Administrative Markets

But there are other considerations, as well. As I've written before, we are now in a period of "administrative markets" where stock returns are affected as much by government policies as they are by economic growth and corporate profits.

In particular, the Fed is laying off the gas pedal, tapering its monthly bond-buying program. That's a good thing overall. The economic recovery is still tepid, but the fact that the Fed is pulling out the monetary crutch means the patient is learning to walk on his own. That's positive.

Another factor is corporate profits. Yes, they've mostly beaten expectations so far this year, but that's only because those expectations were so low. In last year's first quarter, for instance, the companies that make up the S&P 500 rose more than 5% in the first quarter. This year they're up less than 2%.

For stocks to power higher, we need to see sales and earnings accelerate. Unfortunately, Washington isn't lending much help. Congress has saddled companies with Obamacare and hundreds of new regulations. It has raised taxes on high earners, including millions who run a business through an LLC (limited liability corporation). This is having a deleterious effect on economic activity.

The Good News

However, no one has to buy the average company (or the whole market). There are plenty of sectors and dozens of individual companies with superb prospects right now.

Zero in on them. Here are a few characteristics that market leaders tend to have in common:

  1. 10% or better sales growth.
  2. 20% or better earnings growth.
  3. Double-digit profit margins.
  4. High-quality management.
  5. A 17%-plus return on equity. (Return on equity is earnings per share divided by book value per share. It's an excellent indicator of how efficient management is with the firm's capital.)
  6. New product introductions.
  7. Share buybacks.
  8. Institutional support.
  9. Strong technicals. (Good volume and the shares are trading above their 50- and 200-day moving averages.)
  10. Insider buying.

Look for companies that have all or most of these qualities and you are well on your way to making good money, even in a flat or herky-jerky market.

You can't forecast the economy and you can't predict the stock market. But there's one thing you can take to the bank: share prices follow earnings.

So focus on the very best companies with the most robust profit growth. That's how the smart money plays a lackluster market like this one.

Good investing,

Alex

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All Aboard This Profit Machine

You sure don't have to tell shareholders of Union Pacific Corp. (NYSE: UNP) that share prices follow earnings. They've been watching the nation's leading railroad company smash earnings records quarter after quarter... and sure enough, the share price has followed right along.

Shares are up almost 180% since Alex added Union Pacific in 2010, and they're up more than 14% this year. David Fessler (our resident train buff) recently updated Members on the company's performance:

"In spite of severe weather this past winter, the company reported four new records in its first quarter results:

  • Earnings per share (diluted) of $2.38 were up 17%.
  • Operating revenues were $5.6 billion, an increase of 7%.
  • Operating income totaled $1.85 billion, up 14%.
  • Operating ratio of 67.1% improved by two points.

"I'm not surprised. I believe Union Pacific is the best-run railroad in the U.S. Its string of record quarterly results proves it repeatedly...

"The company's first quarter carload volume increased 5% over the first quarter of 2013. Conversely, Union Pacific paid $3.12 per gallon of diesel, a 3% decrease compared to the first quarter of 2013.

"Union Pacific's 10,000 customers represent a diverse group. These include the automotive, agricultural, coal, chemical and industrial sectors. Its intermodal hauling business is one of the largest in the country.

"Union Pacific continually upgrades its track infrastructure. Over the last seven years, Union Pacific spent $21.6 billion on it.

"Its 8,300 locomotives move the company's 283,000 railcars faster than ever. Terminal dwell times as measured in hours have dropped 10% over the last four years.

"Union Pacific's 31,800 miles of track blankets 23 states in the Western U.S. The company connects with Canada's rail system and it's the only U.S. railroad connecting to all six of Mexico's rail gateways...

"Union Pacific spent $683 million on share repurchases during the first quarter. That took 3.8 million shares off the market.

"Earnings-per-share gains nearly always benefit from share buybacks. Union Pacific buys back its own shares every quarter. That should continue to benefit shareholders during 2014 and beyond.

"The Association of American Railroads (AAR) is the keeper of statistics on the railroad industry in North America. According to the AAR, U.S. railroads are responsible for 40% of intercity freight volume.

"That's more than any other mode of transportation. Railroads provide the most affordable and efficient freight service compared to anything else.

"Rail traffic continues to increase compared to last year. There's little room to argue that Union Pacific will continue to produce record results."

- Bob Keaveney with David Fessler

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