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Investment Strategy

A Stock Picker’s Market

By Elliott H. Gue, on Apr. 28, 2014

A good summary of market action since the 2007-09 financial crisis: Risk on, risk off.

In March of 2009, as markets began to perceive signs of “green shoots” for the global economy, stocks rallied sharply. Between March 10, 2009 and April 26, 2010, the S&P 500 soared more than 72 percent, while MSCI Emerging Markets Index soared an even more impressive 111 percent.

Predictably, commodity prices rose alongside stocks as market participants priced in higher consumption of products like oil and corn amid a strengthening global economy.

And, the US dollar fell in value against most major currencies – since the US dollar is considered the world’s “safe haven” currency, it often gains ground when market volatility picks up and loses value when market participants are reaching for returns.

This pattern of rising stocks and commodities accompanied by a falling US dollar came to be known as the “risk-on” trade. The idea was that investors weren’t being selective or betting on particular stocks, commodities or currencies but were taking the view that the global economy was getting better, benefiting all stocks and commodities.

Then, between late April 2010 and Late August of the same year, the European credit crisis reintroduced fear to global markets, prompting many pundits to call for a “double-dip” recession in the US and other major economies.

The resulting “risk-off” trade saw the US dollar gain ground while stocks and commodities fell sharply. Panicky investors were bailing out of economy-sensitive asset classes like stocks and commodities regardless of fundamentals and choosing to stay in cash instead.

Over the past five years we’ve endured multiple gut-wrenching cycles of risk-on, risk-off market volatility. While stocks have generally performed well over this period, rewarding investors who followed our advice and bought the dips, it’s been a roller coaster ride. The risk-on, risk-off trade also became a favorite in the financial media as it was possible to explain virtually any market move by pointing to geopolitical or macroeconomic trends in the news.

But, the risk-on, risk-off market environment is now coming to an end.

The easiest way to measure this phenomenon is to examine the correlation among three key asset classes – the US dollar, stocks measured by the performance of the S&P 500 and commodities measured by the S&P GSCI Index. When the market is in risk-on, risk off mode, the correlation between these three assets should be high.

Source: Bloomberg, Capitalist Times Premium

I produced this chart by examining the weekly correlation between stocks, commodities and the inverse of the US dollar over rolling 12-week periods. When the correlation is high, it means that investors are generally making macroeconomic bets on the broader market, dollar and commodities rather than specific investments based on individual market fundamentals.

As the chart shows, our measure of correlation jumped sharply in the wake of the 2007-09 financial crisis as successful investing became more a matter of catching the trends in macroeconomic data than picking well-positioned stocks in solid industry groups.

But since 2012, the dollar, stocks and commodities have begun to decouple. 

That means that successful investing is increasingly becoming a matter of picking individual stocks and industry sectors, NOT correctly forecasting every modest acceleration or deceleration in global economic data and credit conditions.

To succeed in this changing environment, investors must tweak their strategy.

In Capitalist Times Premium, we continue to recommend stocks leveraged to a handful of key underlying trends.

One of the most important is what we’ve dubbed Morning in America, the idea that US manufacturing and industrial companies are increasingly benefiting from America’s ultra-low energy costs and competitive wages.

recent study released by the Boston Consulting Group (BCG) provides further evidence of this megatrend. In particular, BCG’s study of the 25 largest goods-exporting countries, accounting for close to 90 percent of global goods trade, found that five economies have seen their cost competitiveness erode particularly quickly since 2004: China, Brazil, the Czech Republic, Poland and Russia.

The main drivers of deteriorating competitiveness include sharp wage increases, weak productivity growth, unfavorable currency trends and a “dramatic” rise in energy costs.

In contrast, the same study found that the US economy has become more competitive against virtually all other major exporters around the world due, in no small part, to the world’s lowest energy costs. China’s cost advantage over the US has shrunk to less than 5 percent overall and should continue to fall as US dependence on imported energy supplies continues to fall even as China’s dependence rises. Meanwhile, US manufacturing costs are now 10 to 25 percent lower than the average of the 10 largest goods-producing nations in the world excluding China.

The ongoing trend toward rising US competitiveness in manufacturing is reversing a near five-decade-old downtrend in manufacturing’s importance to the US economy. And this trend is set to accelerate as more manufacturers recognize this ongoing trend and invest to build new capacity in the US in coming years. These multi-year investments will be a major boon to the US economy and employment conditions; investors don’t yet recognize the importance of this sea-change.

In the July 5, 2013 issue of Capitalist Times Premiumwe highlighted auto parts giant BorgWarner (NYSE: BWA) as a play on this trend. BorgWarner specializes in producing turbochargers and transmissions, two key technologies that help automakers boost vehicle fuel efficiency without compromising performance.

The stock performed well, and in mid-April, we booked a profit of more than 46 percent.

However, our Wealth Builders Portfolio still includes a number of plays on America’s growing competitiveness in automobile manufacturing. The list includes an under-the-radar small-cap stock that sits at the heart of one of the most important fundamental changes in automobile manufacturing in decades. And, no, this name has absolutely nothing to do with electric cars.

We also recently added a company in one of America’s oldest industries that recently opened a new manufacturing facility on the US Gulf Coast. This plant will dramatically reduce the manufacturer’s costs thanks to plentiful low-cost natural gas supplies in the region.

Also in our Model Portfolio: An unloved energy play currently in the midst of a restructuring that’s already starting to bear fruit–the stock popped more than 11 percent after announcing encouraging first-quarter results earlier this month. This overlooked company also looks like a tempting takeover target; with the stock already on the move, don’t be surprised to watch a larger player snap this firm up at a mouth-watering while valuations are still attractive.

To learn more about my top picks, why not sign up for a risk-free trial subscription to Capitalist Times Premium?

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