Buy Stock Now to Ride Second Stage of Bull Market: John Dorfman

John Dorfman

From Jan. 19 through Feb. 4, the Standard & Poor’s 500 Index, a decent gauge of the overall U.S. stock market, dropped about 8 percent.

Among the reasons sparking the decline were President Barack Obama’s proposed tax on banks and a congressional deadlock on health-care legislation. Some stock-market pundits take the drop as a sign that the stock surge that began March 9, 2009, is over, or almost over.

I believe the rally will continue. The recent slump, in my view, was normal. The U.S. stock market historically has averaged at least three declines a year of 5 percent or more, and one fall of 10 percent or more, according to Ned Davis Research Inc. I think the rally will resume and run -- with unpleasant interruptions, to be sure -- through most of 2010, and possibly longer.

Ned Davis, head of NDR, is one of my favorite analysts. His firm predicts a decline, perhaps even a “mini bear market,” during the second and third quarters. It expects the market to advance again after that.

The Ned Davis team recommends that investors go “defensive” during that six-month stretch by buying the kinds of stocks that usually hold up better in declining markets: consumer staples, health care, utilities and telecommunications stocks.

The Davis folks have given those four groups the acronym SHUT (staples, health, utilities, telecom). When the SHUT stocks break above their 200-day moving average, they say, investors should climb onboard.

Saw-Tooth Advance

Although I respect Davis, I’m not about to play defense. I don’t think the year will divide, like a concerto, into three distinct movements: up, down, up.

Rather, I think the market will move in saw-tooth fashion, up and down all year, but with more ups than downs. Accordingly, I am staying with my “offensive” stocks: materials, energy, and industrial companies.

In the materials field, for example, I recently purchased shares of Innophos Holdings Inc., a small chemical company located in Cranbury, New Jersey. Innophos makes phosphate salts and other chemicals used for water treatment, as flavor enhancers, in pharmaceuticals, and for other applications.

Chemical companies, like producers of steel and other metals, tend to rise and fall with the tides of the economy. Right now, in my view, the tides are rising.

Evidence of Recovery

Look at the fourth-quarter tally of the gross domestic product. It rose at a 5.7 percent annualized pace, the strongest reading since the third quarter of 2003.

Or consider the Conference Board’s index of leading economic indicators. It has risen nine months in a row, from April through December.

Auto sales are gaining, home prices have firmed in many cities, and technology orders are improving. All in all, the evidence points to an enduring recovery, in my view.

If the economy is indeed recovering, it would be shocking for the stock market’s advance to stop abruptly. There has been a historical pattern, and the market seems to be following it. A terrible event such as a major terrorist act could, of course, cause markets to abruptly change direction.

Second-Stage Bull

During most bull markets, the first 40 percent or so of stock market gains occur in a spurt before an economic recovery begins. This time, that would be the period from March through, say, September.

The remaining 60 percent of the gains usually occur more gradually and haltingly during the next year or two, as the economic recovery unfolds.

Energy stocks usually do pretty well during the second stage of bull-market advances. Today, there are lots of energy companies I like.

One is Atwood Oceanics Inc., an oil and gas drilling contractor. Though the company is based in Houston, less than 5 percent of its revenue comes from the U.S. The bulk of its sales are from drilling in the Mediterranean and Black Seas as well as offshore sites in Asia and Australia.

Atwood increased its fiscal year revenue to $587 million in 2009 from $161 million in 2004, and did it in the teeth of an economic slowdown. With that record of growth, I think the company should sell for more than the current multiple of nine times earnings.

Twin Disc Undervalued

Plenty of industrial stocks look good to me now. One is Twin Disc Inc. of Racine, Wisconsin, which makes heavy-duty transmissions used in off-highway vehicles, yachts and other large boats. In the nightmare year of 2008, Twin Disc shares dropped to about $7 from about $35. They have recovered only modestly since, and now trade for a bit less than $10.

At that price, the shares are trading right around book value, a sign of a possible bargain. The price-earnings multiple looks bad, at near 30, but that is because earnings are evaporating-- temporarily, I believe.

After a profit of $1.03 a share in fiscal 2009, analysts look for earnings to fall to about 18 cents a share in fiscal 2010, which ends in June, and recover to 94 cents the following year.

Twin Disc is well managed and happens to be economically sensitive. It has endured some pain, and now I think it will reap some gain.

Disclosure note: I own shares of Innophos and Twin Disc personally and for clients. I have no long or short positions in Atwood Oceanics at this time.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

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To contact the writer of this column: John Dorfman at jdorfman@thunderstormcapital.com.