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Investment Strategy

Screening for Winners

By Elliott H. Gue, on Nov. 29, 2014

From its intraday high on Sept. 19 to its intraday low on Oct. 15, the S&P 500 gave up almost 10 percent of its value—the biggest correction since 2011.

After pullbacks in 2010 and 2011, the point at which the S&P 500 climbed above its 200-day moving average marked an ideal opportunity to re-enter the stock market.

We expect the market’s most recent retrenchment to follow the same pattern; the S&P 500 closing above 1,906—the index’s 200-day average—would send a strong signal that the market should rally through year-end.

CT-Evergreen-1

With the US economy continuing to strengthen, investors should regard recent weakness in equities as an excellent buying opportunity.

Economic Indicators Remain Bullish

The Bloomberg Economic Surprise Index quantifies how the past six months of US economic data stacked up relative to Wall Street’s consensus estimates. This index attaches greater weight to recent releases. Readings greater than zero indicate that, in general, economic data points have surprise to the upside.

(Click graph to enlarge.)BBerg US Economic Surprise Index

Although the Bloomberg Economic Surprise Index has pulled back from its recent high, the last negative readings came in early 2014, when disruptions related to the polar vortex distorted economic data.

Against this backdrop, we expect US economic growth to hover around 3 percent next year—well above the 2.2 percent to 2.3 percent expansion rate that’s prevailed over the past three years.

Published monthly by the Conference Board, the Leading Economic Indicators (LEI) incorporates the performance of 10 data sets that historically presage major directional shifts in US economic growth.

A negative year-over-year change in LEI has reliably warned of an impending recession since the late 1950s. On that basis, the economy appears to be on sound footing: This metric has increased steadily since early 2013, and in August 2014 climbed 6.8 percent from year-ago levels.

LEI Index

And over the six months ended August 2014, eight of the LEI’s 10 underlying components have added to the index’s overall value.

Manufacturing has been a bright spot for the US this year. The Institute for Supply Management’s New Orders Index—one of the leading economic indicators in the Conference Board’s index—stood  at 60 in September, near the high end of its five-year range.

Readings greater than 50 suggest that orders for manufactured goods are expected to increase; changes in the pace of incoming orders tend to lead shifts in factory activity by a few months.

Timing market corrections of 5 percent to 10 percent is notoriously difficult. However, strong US economic growth and a solid start to third-quarter earnings season should be enough to propel the S&P 500 to new highs by the end of 2014 or in early 2015.

Opening the Screen Door

During the stock market’s most recent pullback, only 10 percent of the names in the S&P 500 managed to post gains.

Stocks that outperform when the market swoons often enjoy the support of institutional investors that have the conviction to buy these names despite weakness in the broader market. These stocks also tend to outperform when the market heads higher.

To identify potential investment opportunities, we screened the S&P 500 for equities that meet the following criteria:

  • Exhibit  a three-year beta greater than 1;
  • Rank in the top 25 percent of all S&P 500 stocks by 12-month total return prior to the pullback; and
  • Rank in the top 25 percent of all S&P 500 stocks by total return during the market’s swoon.

A stock’s beta indicates how the shares tend to perform relative to the S&P 500. Equities with a beta below 1 tend to fluctuate less than the broader market, while stocks with a beta greater than 1 exhibit more volatility. Because consumer staples and other defensive names tend to outperform when the market pulls back, we excluded stocks with a beta below 1.

Our screen also seeks to eliminate stocks that outperform solely because of short-term catalyst, focusing on names that delivered superior returns during the pullback and in the 12 months leading up to the pullback. These stocks have outperformed in bull and bear markets, displaying relative strength in varying conditions.

This screen isn’t a shot in the dark. When the S&P 500 pulled back 7.5 percent between May 22 and June 24 of last year, stocks meeting pur criteria returned 27.1 percent over the next six months, easily trumping the broader market.

And when the S&P 500 suffered a 6.1 percent correction between Jan. 15 and Feb. 5, 2014, stocks identified by our screen rallied 17.4 percent over the next six months. The S&P 500, in contrast, gained 10.7 percent.

Our table highlights the name that met these criteria for the Sept. 19 to Oct. 15 pullback.

(Click table to enlarge.)
Screen Gems Table

Investors should never purchase any stocks solely on the basis of a screen; a firm understanding of a company’s underlying business and its growth prospects is critical to separating names that merely look good from those that have the best chance of outperforming.

Nevertheless, screens of this nature can help to generate profitable investment ideas.

First and foremost, our table includes a number of industrial and consumer-oriented names that offer leverage to a strengthening US economy and the stimulus of lower oil prices. These pockets of strength suggest that some of the smart money is betting that US economic activity will keep humming away in 2015.

These results also serve as a reminder that energy stocks underperformed handily during the market’s most recent swoon, reflecting the downturn in US and international oil prices.

That our screen turned up only one energy name—independent refiner Tesoro Corp (NYSE: TSO)—is also illuminating.

Like most manufacturing concerns, refiners profit when their input costs fall relative to the value of gasoline, diesel and other refined products. Well-positioned US refiners have reaped the rewards from domestic crude oil’s wide discounts relative to international benchmarks.

About two-thirds of Tesoro’s refining capacity is located on the West Coast, where a lack of inbound pipelines has limited access to the growing abundance of discounted US crude oil. California, for example, still imports the majority of its oil from Saudi Arabia and other international suppliers at higher prices.

A series of crude-by-rail projects will enable Tesoro to feed its refineries with more than 300,000 barrels per day of domestically produced crude oil, lowering input costs and bolstering profit margins.

Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

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