I’m a bit of a political junkie, but I was getting as tired of the mess in Washington as everybody else. It’s a relief to talk about what’s actually going on in corporations, the economy and the stock market! In other words, investors are going to finally turn their attention back to fundamentals. And in the past when we’ve been in fundamentally focused markets, our Blue Chip Growth stocks have typically prospered and substantially outperformed the S&P 500.
I look for a repeat performance here at the end of 2013, as several factors continue to line up that are positive for the overall market—and especially good for the superior stocks on our Buy List. Here’s a look at the most significant factors:
The Flight to Quality
We’ve talked before about “froth” in the stock market, and I’m here to tell you that it has flamed out and the crème de la crème is rising to the top. This is perhaps the biggest change in the market, and very few people are talking about it. But if you’ve been with us for a while here in Blue Chip Growth, you know we’ve had it on our radar for a long time.
This flight to quality has intensified recently, and that’s a big reason why our stocks have outperformed. At my management company, we test what’s working on Wall Street at the end of each quarter, and all of a sudden, the top 20% of stocks in our combined fundamental screens are breaking out and leading the overall market. I remain impressed with the relative strength that our fundamentally superior Blue Chip Growth stocks have demonstrated in recent weeks, and I expect that to continue.
Let me recap what’s been going on. During the market’s incredibly strong run, with the S&P up about 35% since June 2012, a valuation problem has emerged. The reason is index funds, which force investors to buy all of the stocks—good and bad—in the underlying index. Due to all this buying pressure, low-quality stocks have been flying higher, and some higher-quality stocks have been bid up to unsustainable valuations.
A great example is Tesla (TSLA). I’m a car guy, and there’s no doubt Tesla makes great cars. But the stock? I wouldn’t go near it, even with the company’s explosive sales and earnings growth.
Over the summer, TSLA was added to the NASDAQ 100 (QQQ) to replace Oracle (ORCL). As investors bought the QQQ, money flowed into TSLA as well, automatically increasing buying pressure in the stock. The problem is that this indiscriminate buying comes without any valuation analysis.
In TSLA’s case, it got so ridiculous that the company hit a market capitalization in excess of $23 billion, which is over 10 times its annual sales pace and 440 times its forecasted earnings! And it’s not just the QQQ. Plenty of other index funds were buying Tesla as well, such as those with a small-cap bias or those that go after explosive sales and earnings.
With the proliferation of exchange-traded funds (ETFs), this ETF-induced mechanical buying of stocks without regard for valuation has become a problem for Wall Street. We’re seeing more and more astronomical market valuations and price-to-earnings (P/E) ratios.
I want to stress that we don’t have a valuation problem. This froth does not exist in our Blue Chip Growth stocks, which trade at barely 17 times median forecasted earnings, so we’re getting growth at a reasonable value. This is right where we want to be, as sky-high valuations won’t last. Investors will turn away from ridiculously valued stocks and toward those with strong fundamentals that are reasonably valued.
One thing the government shutdown did not delay is earnings announcement season. It got under way right on schedule when Alcoa (AA) led things off with its report on October 8. According to my friends at Bespoke, 2,218 companies will report over the next month!
I’m especially excited about this earnings season. Earnings in general are finally improving and are expected to gather momentum through the remainder of the year, so this announcement season and the next one in January should be positive.
When it comes to sales and earnings, our stocks really separate themselves from the pack. Our average Blue Chip Growth stock is characterized by more than 17% annual sales growth and in excess of 50% annual earnings growth. To put that into perspective, that’s 5 times the expected annual sales growth of 3% at S&P 500 companies, and more than 8 times the S&P 500’s expected annual earnings growth of 6%. This is outstanding.
Believe it or not, there is at least one silver lining to the recent fiscal irresponsibility of our elected leaders. The embarrassment before the rest of the world with their posturing and dysfunctional politics has put the U.S. dollar on a slippery slope in recent months. A weaker dollar is great for future earnings of multinational corporations. I have been steering clear of many multinationals because a stronger dollar was weighing on their earnings potential. However, with the dollar significantly weaker, I’ll be on the lookout for more opportunities in multinationals.
The Fed and QE
There has been plenty of uncertainty about fiscal policy in Washington, but there is no doubt anymore about who will succeed Ben Bernanke as Chairman of the Federal Reserve. President Obama officially nominated Fed Vice Chair Janet Yellen, who will take over when Bernanke’s term expires in January.
This increases my expectation that quantitative easing (QE) will continue. At the nomination announcement, Yellen said that “more needs to be done to strengthen the recovery.” And she added, “Too many Americans still cannot find a job and worry how they will pay their bills and provide for their families.” She also said that the Fed can help by ensuring that everyone has the opportunity to work hard and build a better life, so it’s clear she takes the Fed’s mandate to lower unemployment very seriously.
In other words, the Fed will likely keep its money pump primed under Janet Yellen. Weaker economic news, ongoing problems in the job market, the government shutdown, a lack of consensus within the Fed, and rising Treasury yields are all excuses that the Fed will use to continue QE for the foreseeable future. Any tapering will likely be postponed until next year, which should be good news for the market and our stocks as we wrap up 2013 and head into 2014.
Here’s another positive effect of the Fed’s 0% interest rate policy and relentless quantitative easing: They are a “flashing light” for corporate America to continue borrowing in the bond market at ultra-low interest rates (typically 3% or less) and aggressively buy back shares of their stock. This boosts earnings per share (with fewer shares trading on the market), supports the stock’s price, and is an expression of confidence from management.
Our Blue Chip Growth stocks have a median Return on Equity (ROE) of 24.2%, and when a company can borrow well below its ROE, Chief Financial Officers are trained to take advantage of the low interest rates and buy back their stock. Many of our Buy Liststocks have relentless buyback programs, and those buybacks along with improving earnings are reasons why they often bounce back so quickly.
So we have the flight to quality, the Fed and fundamentals pointing in the right direction, and it’s all happening as we hit the strongest time of the year for the market. Since 1928, the S&P 500 has gained 0.6% in November and 1.4% in December. The end-of-year holidays put people in a good mood—and a spending mood—and you also have a lot of year-end pension funding that boosts stocks.
I am especially optimistic this year, and believe that we will have a lot of be thankful for this Thanksgiving.