Marching to a Muddle of Mixed Signals

Stock-picker Ned Davis is pretty certain the bulls have a ways to run. Just how far and for how long? Well, those are tougher calls

By Gene Marcial

Despite the Street's strong showing in the past seven weeks, skepticism continues to surround the fate of stocks over the coming months. The muddling, though growing, U.S. economy is making it difficult for investors to forecast just how much strength the current rally can muster.

Although indications are that there will be "money-making opportunities on cyclical swings going forward," the market is still in a "difficult secular environment," says Ned Davis, chief investment strategist at the highly respected Ned Davis Research in Atlanta. This is partly because the economy has yet to fully warm up, according to some market watchers. Meanwhile, some economists persist in warning that the looming problem may be deflation. The common ground: The conditions that characterized the secular bull markets of the 1980s and the 1990s have yet to return.

The market has shown a lot of improvement since the sharp fall after hitting its peak in 2000, notes Davis, who adds that it has yet to send what he calls an "all-clear signal" that a secular bull market is definitely here. Nonetheless, the portfolio Davis recommends is overweighted in stocks, which account for 65% of allocated assets, while bonds represent 35%.


  Davis says the improving outlook for corporate profits favors stocks. "The case for stocks over bonds is also supported by the evidence that the stock market bottomed in October...and the fact that nearly a third of the 33 Ned Davis Research-defined cyclical bull markets since 1900 have started in either September or October," says Davis. During such cyclical bull markets, the Standard & Poor's 500's total-return index outperformed the Ibbotson long-term bond total return by nearly 20 percentage points, he notes.

Ned Davis Research's charts don't show that the market has been way oversold, as it was during the other secular market lows, so there are still considerable longer-term risks. There has been considerable pessimism, for one, during the recent market low, setting up a favorable trading outlook. But, cautions Davis, "We did not get to the 61% level of bearishness seen at past major lows."

The pluses, however, include the "bottom confirmation readings" on 7 of the 10 indicators that Ned Davis Research tracks. The Federal Reserve Board's latest cut in short-term interest rates provides an additional boost to the monetary environment. And sentiment indicators also flash positive signals that the market is not vulnerable to a major weakness ahead.


  So how does an investor deal with a muddling economy and a stock market that appears intent on pushing upward? Based on sector leadership in similar economic environments from the early 1980s to the early 1990s, the consumer-discretionary and financial sectors provided the strongest and most consistent performance, says Lance Stonecypher, the senior equity-sector strategist at Ned Davis.

Among the underperformers were energy, utilities, telecom services, materials, and industrials. Low interest rates continue to drive home-mortgage refinancing activity, notes Stonecypher, and the GOP's recent victory in the midterm congressional elections increases the likelihood that a number of tax cuts will be made permanent. These should benefit the consumer-discretionary sector, he says. Within this sector, manufacturing, especially in apparel, accessories and homebuilding, will benefit, he says. The political landscape also has improved for health care, says Stonecypher, with less likelihood of price controls on brand drugs and kinder treatment of HMOs anticipated under a Republican version of a bill of rights for patients.

Oil prices and energy are the wild cards, Stonecypher notes, with much depending on any military campaign against Iraq, with a short and successful war -- or perhaps no war at all -- would lead to lower oil prices. Because the Republican's victory in Congress fuels hope of increased exploration, the only overweighted energy sector is oil-drilling.


  Among the top-ranked stocks on the Ned Davis Research Focus List, the choices are quantitatively based and designed for portfolio picks for the next three months to four months. Dominant in these choices are housing-related stocks, retailing, and financial services, such as banks. Among them: Homebuilders KB Homes (KBH ), Lennar (LEN ), and Ryland (RYL ). In general apparel retailing, Coach (COH ), Columbia Sportswear (COLM ), Liz Claiborne (LIZ ), and Reebok (RBK ) make the list. And in financials, there are UCHB Holdings (UCBH ), Golden West Financial (GGDW ), and Northwest Bancorp (NWSB ).

The Focus List is obviously targeted with a keen eye on the expected rise in consumer spending. Despite all worries about declining confidence in U.S. malls and shopping centers, it seems that, when it's time to pick stocks, consumers continue to rule.

Marcial is BusinessWeek's Inside Wall Street columnist

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