How to Play This Flat Market
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.
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:
- 10% or better sales growth.
- 20% or better earnings growth.
- Double-digit profit margins.
- High-quality management.
- 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.)
- New product introductions.
- Share buybacks.
- Institutional support.
- Strong technicals. (Good volume and the shares are trading above their 50- and 200-day moving averages.)
- 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.