Stocks: The Next Hot Sectors

Amid the volatility, Gene Marcial talks with stockpicking pros about the market sectors they see leading the next major advance

I always say try not to pick the market's bottoms or peaks. Leave that to the pros. Such guessing will only sabotage your sober perspective. That is not to say that you shouldn't prepare for the market's next move, whatever it may be. More than a few market prognosticators are already quite sure the stock market's next big move will be up. Could they be right? Most investors aren't betting on it. But that may be one of the reasons a bull-market rally could be just around the corner. Of course, no one rings a bell to alert investors the bull is stampeding back.

"All signs are out there now for the market to move to the next cycle, which is best described as the next 'greed wave' that will propel the next advance," says Steven Charest, chief market strategist at Divine Capital Markets in New York. The "fear factor" wave is just about over, he says. Sure, there will be bouts of profit-taking as rallies occur. After all, there is a lot of uncertainty surrounding the economy and the liquidity and financial crises.

The stock market continues to be volatile. On Mar. 18, the Dow Jones industrial average exploded and soared 420.41 points, a 3.15% gain, to 12,392.66, spurred by the Fed's move to increase liquidity for financial institutions and the Fed-engineered bailout of Bear Stearns (BSC) by JPMorgan Chase (JPM). And on Mar. 24, the Dow again blitzed higher, shooting up 187.32 points, or 1.5%, to 12,548.64. Predictably, the market surrendered some of its gains. The Dow on Mar. 27 fell 120 points, or 1%, to close at 12,302.46—a drop of 229 points in two days. The Nasdaq tumbled nearly 2% the same session, spooked by slower sales at Oracle (ORCL).

Not So Fast, Say the Bears

What to do at this juncture of the fickle market? Prepare to snap up shares in groups that promise to be big players in the market's next major move. It is important to determine which stocks will sparkle and to identify the sectors likely to lead the next parade. Some savvy pros have assembled some names in those sectors.

Technology, industrials, and infrastructure/construction—and yes, some energy and financials as well—stand out as the batch of potential big winners the next time around. Here are some stocks that some smart-money pros picked: in technology, Corning and Diodes; in industrials, Itron, Joy Global, and Fuel Tech; in infrastructure/construction, Chicago Bridge & Iron; in energy, Schlumberger, Transocean, and Weatherford International; and in financials, Wells Fargo and U.S. Bancorp.

This is not to say the bears have thrown in the towel. They continue to growl loudly and to predict that investors will suffer more pain. "The market is in imminent trouble. Expect the worst," warns Bert Dohmen, editor of Bert Dohmen's Wellington Letter in Los Angeles, a newsletter that focuses on the Fed, economic issues, and the stock and bond markets. If the worst doesn't happen, "it will be a pleasant surprise," but don't go down the slippery "slope of hope," which so many analysts use today, Dohmen says. He notes that financial stocks continue to be pummeled. "No stock market rally can go far without the banking stocks," he argues.

Steve Rogé, an investment manager at R.W. Rogé, is also not sanguine about the outlook. There are "pockets of opportunity" for value investors, he says, but he expects any market bounce would last for just a month or so. "The recession may have been already priced into the market, but not the credit bubble," warns Rogé. He expects the Standard & Poor's 500-stock index to fall to 1,200 before any meaningful advance takes place. The S&P 500 finished at 1,325 on Mar. 27, down nearly 10% for the year.

Eye Out for the Early Cycle

Nonetheless, some equally intransigent market observers believe otherwise.

Jeffrey Kleintop, chief market strategist at investment firm LPL Financial in Boston, says we may have already witnessed the "definitive action we have been looking for" to prompt the stock market to swing from late-cycle behavior—where price-earnings ratios are falling and energy and basic materials are the best-performing sectors—to early-cycle behavior, with p-e ratios rising and the market leadership shifting to sectors such as consumer discretionary.

He notes that in recent weeks, the dollar rose in combination with the sharpest decline of commodity prices in more than 50 years. That combination, he explains, shifted the sentiment on inflation, which boosted the stock market and switched stock leadership away from the energy and materials sectors, as the price of oil fell by about $10 a barrel and gold dropped by $100 an ounce. Kleintop points out that this reversal in the direction of the dollar and commodity prices—two important factors that affect inflation—may have marked a shift to the early-cycle positive environment that, in the past, delivered powerful returns to investors.

Investors should not wait for economic data to improve before buying into the market, Kleintop advises: "Markets historically have bottomed well before the economy began to rebound—especially during recessions." As an example, employment usually continues to fall for 12 months after the markets begin to rally. Since World War II, stocks have rebounded before the end of every recession. The S&P 500's gain from a recession's low point until the end of the recession has been 25% on average, Kleintop says.

Overlooked Tech and Industrials

With globalization now a big factor, stocks with interlocking interests in markets around the world appeal the most to the pros because they are likely to dominate the next advance. "We remain focused on companies building, supplying, or financing productive capacity globally," says Divine Capital's Charest. To him, this suggests shares of technology and industrial enterprises will lead the next advance, driven by global demand for infrastructure and real productive assets.

Most investment managers favor the widely held large-cap stocks in these sectors. Not Charest. He doesn't go for the usual coterie of popular stocks that most institutions snap up. Topping his technology picks is Corning (GLW), a major maker of glass substrates used by the electronics industry. It is also a producer of fiber-optic equipment used by the telecom industry. Now trading at 24 a share, Corning is off only slightly from its 52-week high of 27.22 in July, 2007.

Another of his tech picks is Diodes (DIOD), which makes discrete semiconductor products for the communications, computing, industrial, electronics, and automotive markets. The stock, now at 23, is down from its 52-week high of 35 in October.

Among industrials, Charest again shuns the institutional favorites. Instead, he favors Itron (ITRI), the global leader in advanced meter-reading equipment for collecting and analyzing data on electricity, natural gas, and water use in residential, commercial, and industrial locations; Joy Global (JOYG), a Milwaukee-based maker of high-productivity mining equipment for the extraction of coal and other minerals and ores; and Fuel Tech (FTEK), which develops air pollution-control technologies and provides engineering services.

These industrials were highfliers in the past, but are now down from their highs. Itron shares zoomed from 65 on Apr. 3, 2007, to 112 on Oct. 30, but they're now trading at 93. Joy Global shot up from 42 in March, 2007, to 72 a year later; the stock is now at 65. Fuel Tech has fallen to 19 from a high of 38 in June, 2007.

Bottom in Financials?

How about the beleaguered financial stocks? Charest believes they deserve some attention as well. "The charts suggest a bottom in financials is close, led by the regional banks," he says. But Charest is steering clear of the major commercial and investment banks. Instead, he favors shares of HSBC Holdings (HBC), part of Britain's HSBC Group that provides a variety of international banking and financial services. It is one of the few financial institutions whose stock hasn't been severely battered. It is trading at 81, down from a high of 99 reached on Oct. 31, 2007.

Charest also favors Old Republic International (ORI), a Chicago-based insurance company that offers property and liability, mortgage guaranty, title, and disability protection. Now at 12, the stock is down from 22 in April, 2007. Old Republic has an attractive long-term total-return profile, notes Charest.

Chicago Bridge & Iron (CBI), Weatherford International (WFT), and Transocean (RIG) top the choices of Martin Sass, who heads investment management firm M.D. Sass. He says the rapidly expanding global projects on infrastructure and construction are boosting sales and earnings at Chicago Bridge, a major engineering and construction company primarily serving the energy industry. Sass says the fast-growing liquefied natural gas infrastructure work at energy companies represents about 50% of CBI's 2007 revenue. The company has a yearend backlog of $7.7 billion worth of work. So Sass projects 2008 earnings will jump 59%, to $3 a share, and by 30% in 2009, to $3.90. Now trading at 39, Chicago Bridge should hit 68 in a year, Sass figures.

Optimistic on Oil and Gold Stocks

Weatherford International is the fastest-growing company in the oil services industry, with projected earnings growth of 30% a year for the next five years, according to Sass. He is impressed by the Houston company's rapid expansion in overseas markets, and expects 2008 earnings to rise to $4 a share in 2008 and to $5.85 in 2009, vs. 2007's $3.33. He expects Weatherford's stock, now at 70, to vault to 100 in a year.

Transocean is the world's largest and premier offshore drilling rig contractor, with strong earnings visibility because of long-term contracts, says Sass. It is another company whose earnings are growing at a fast pace. Sass expects 2008 earnings to surge 81%, to $14.50 a share, up sharply from 2007's $8. For 2009, he projects earnings will jump to $17 a share. The stock, now at 134, is extremely cheap, says Sass. He figures the stock of the Houston firm will climb to 170 in a year.

Although commodity prices have softened in the past few weeks, some investment pros remain bullish not only on the oil sector but on gold stocks. One such bull is Stephen Leeb, president of Leeb Capital Management, who believes strongly that Schlumberger (SLB) will be among the solid gainers in the energy group. He is also a fan of Transocean. He sees Schlumberger and Transocean as "dirt cheap" plays trading at historically low p-e ratios. Schlumberger, now at 85, hit a high of 114 in October, 2007. Leeb sees the stock at 100 in 6 to 12 months.

In precious metals, Leeb is a stalwart bull on Barrick Gold (ABX) and Newmont Mining (NEM). "I like gold because the extraordinary monetary and fiscal stimulation by the Federal Reserve Board will likely raise inflationary expectations," says Leeb. Both Barrick and Newmont are the safest investments in the gold industry, he adds, and could jump more than 15% over the next three to six months. Barrick, at 45 a share, is down from its high of 54 earlier in March. Newmont, now at 46, is off from its January high of 57.

Even Financial Stocks Could Shine

Leeb doesn't confine his bullishness to oils and metals. He also believes some of the financials are a must-buy at this point. Wells Fargo (WFC) and U.S. Bancorp (USB) are well positioned, he says, to gain market share during the credit crisis. Both stocks could easily rise by more than 20% in the next three to six months, Leeb figures. Now at 30, Wells Fargo is trading not far from its 52-week high of 38 in September, 2007. And U.S. Bancorp, at 33, remains near its 52-week high of 35.

Certainly, the banks face forceful headwinds. The protracted housing slump, credit quality deterioration, and slower U.S. economic growth have burdened nearly all financial institutions. But Wells Fargo is well positioned to mitigate some of the challenges and should continue to expand its banking operations, says Frank Braden, banking industry analyst at Standard & Poor's. "We see Wells Fargo deploying more capital toward potentially faster-growing business segments and focusing on fee-income growth," he says. The bank's conservative sales culture and higher credit-quality standards, says Braden, will support its ability to achieve above-average earnings growth for the long term. There is no denying, however, that there has been some deterioration in Wells Fargo's home-equity loan portfolio because of falling housing prices. Even so, he thinks solid loan growth in Wells Fargo's other businesses will offset expected challenges.

U.S. Bancorp is one of the most profitable major banks, notes Leeb, based on its returns on equity and assets. Its diversified business model emphasizes fee-based revenue growth. However, it expects to post higher commercial real estate net charge-offs in 2008. But Leeb says the Minneapolis bank is focusing more on loan quality than loan growth. So mortgage banking revenue, he believes, will gradually increase from its currently depressed levels. And Leeb figures credit quality should remain resilient.

Regardless of whether the market hits bottom any time soon, the stock picks mentioned here hold positive fundamentals that would serve them well in up or down markets. But in a major advance, their returns would truly shine. When it comes to the next big rally, there's nothing better than being prepared.

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