To Trend or Not to Trend

Attempts to forecast the end level of the market for the year in January have about as much precision and integrity as a monkey throwing darts. Yet, it is useful to spend time outlining your expectations for the year, even in January. According to Dennis Slothower, editor of Stealth Stocks , 2004 represented a uniquely difficult market environment in which to invest due to the oscillation between dominant trends and trading ranges. There are compelling cases to be made both for the market to succumb to a dominant trend in 2005, as well as for it to be constrained in a tight range. The Experts lay out their historic and contemporary cases for the market to do each and proffer the stocks and strategies they will pursue to thrive in ’05.

5 Year Performance & 5th Years

According to Slothower, a trend is a consistent move over a period of time, and he likes to take a big picture look in order to discern that trend. 50-, 100-, and 200-day moving averages, as well as Bollinger Bands are useful for determining the nature of the trend in which the market finds itself. It is a losing proposition, Slothower thinks, to attempt to pick stocks and buck the trend, as “a rising tide lifts all boats” and stocks tend to fall together. However, trends of varying term lengths can work in opposition to one another, and economic cycles tend to have longer periods of frequency than trading trends.

Presently all three major indices sit below their all time highs and the levels where they traded 5 years ago. The Dow Industrials is just -5% below its levels of a half decade ago while the NASDAQ and the S&P 500 are down -55% and -17% respectively. These factors persuade Dennis Slothower that the Federal Reserve will likely step in and aggressively support the market through loose monetary policy in order to propel the indices to a growth rate more amenable to the Fed’s expectations.

Donald Rowe, editor of the Wall Street Digest agrees that the Federal Reserve’s policy will be supportive of stock market returns in 2005. Beyond liquidity, rising interest rates will drive dollars into equities in search of returns. As rates rise, bond prices will fall, removing their attractiveness as investments. Beyond Fed support, though, Rowe observes that the 5th year of each ten-year cycle tends to launch the market to significant returns. In fact, since 1915, the average returns for the 5th year of each decade has been 34.2%. Even in the middle of the Great Depression, stocks zoomed 38.5% in 1935. The first two-three years of each decade since 1920 has seen a recession and bear market followed by a significant bull market.

Rowe expects even relative outperformance to other such periods thanks to the Fed’s liquidity support and the $6 trillion sitting on the sidelines. According to one of Greenspan’s favorite charts that Rowe cites, the IBES Valuation Model to prove the market is about 33% undervalued. The model compares the earnings yield (earnings/price x 100) of the S&P 500 based on its current level and the 12-month forward earnings estimate, to the current yield of the 10-year Treasury note. Rowe notes the chart predicted the crash in 1987 and the bursting of the Internet bubble, and he currently feels it points to a strong rally in the offing.

Act Now

Rowe expects small and mid-cap stocks to continue their leadership within this bull market. Since the market bottomed in August, 2004, Rowe notes the Russell 2000 Small Cap Index has outperformed all other indices, most significantly leading the Dow Jones Industrial Average and the S&P 500, which have lagged. Two stocks he likes are Image Entertainment, Inc. (NASDAQ: DISK - Snapshot Report ) and Knight Transportation, Inc. (NASDAQ: KNGT ).

Image Entertainment, Inc. is a leading independent licensee, producer and distributor of home entertainment programming, with more than 2,500 exclusive DVD titles in domestic release and approximately 300 programs internationally via sublicense agreements. Image Entertainment releases an average of over 40 new DVD titles each month. The company acquires exclusive titles from many content holders, including independent program suppliers, producers, music artists, record labels and artist management. Over the past three quarters, Image Entertainment has realized earnings growth of 700%, 200%, and 600% on sales increases of 41%, 75%, and 21%, respectively. This fiscal year, the company is expecting earnings of $0.26 per share, a 167% increase from last year. Long-term earnings are expected to average 28% annually.

Knight Transportation, Inc. is a short- to medium-haul, truckload carrier that transports general commodities, including consumer goods, packaged foodstuffs, paper products, beverage containers, imported and exported commodities, and refrigerated goods throughout the United States. The company provides regional truckload carrier services from 12 separate facilities and also has 253 tractors under contract, which are owned and operated by independent contractors. From its 12 facilities, the company operates 15 operating divisions and concentrates its freight operations in an approximate 750-mile radius around each of its terminals. Over the past four quarters, Knight Transportation has realized earnings growth of 38%, 25%, 23%, and 13% on sales increases of 30%, 26%, 22%, and 14%, respectively. This fiscal year, the company is expecting earnings of $0.80 per share, a 29% increase from last year. Long-term earnings are expected to average 25% annually.

Slothower agrees with Rowe on the 5-year cycle, and believes that the cards are aligned for a positively trending market. In fact, he thinks the market will continue its time above its major moving averages. Presently, he is loosening some of his stop losses in order to lock in profits. He currently recommends Prosperity Bancshares Inc. (NASDAQ: PRSP - Snapshot Report ).

Prosperity Bancshares, Inc. is a bank holding company headquartered in Houston,TX, that owns all shares of Prosperity Bank (Bank). If offers a provides a broad line of financial products and services to small and mediumsized businesses and consumers through 51 banking locations as of May 2004: 29 in the Greater Houston Consolidated Metropolitan Statistical Area, 11 in eight contiguous counties situated south and southwest of Houston and extending into South Texas and eleven in the Dallas/Fort Worth area. Prosperity Bancshares (PSRP) is a quite little bank that continues to put up big numbers. It is small enough to fly under the radar screen of Wall Street and allow us to take advantage of its obscurity, which according to my numbers is undervalued. Close to 25% of the outstanding share are held by insiders and I always like to see management eating their own cooking. Management has also done a very fine job by way of the 14% return on equity (ROE). According to Slothower’s numbers, this is a stock that should be selling in the high $50s to low $60s over the next three to five years. It is currently trading in the low $30s, so PRSP has a large upside potential. Place a sell stop at 25 percent below your entry price.

Exciting Prospects

Both Slothower and Rowe are aware of the risks faced by the market and are not charging blindly ahead. However, the two self-identified optimists do feel that the deck is stacked in the market’s favor for 2005, and things will move well. So, chart your path, and enjoy.

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(Editor's note: Trace Johnson is a market commentator for Zacks Investment Research. He's also a regular contributor on WebFN, First Business and CNBC-Europe. He can be reached at tjohnson@zacks.com)