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Investment Ideas

We are just days away from closing the books on a fairly good year for the stock market. The broad consensus in the market is for the trend to continue into the New Year, giving us gains comparable to what we got in 2012. Driving this optimism is a combination of the improving domestic housing scene, a less worrisome Europe, and signs of life in the China growth story.

With all the hand-wringing surrounding the fiscal uncertainties, one would have expected investors to be a lot gloomier in their outlooks. But that’s not what we see in the market.

So is that it? Should we find assurance in the market’s recent price action and stop worrying about the U.S. and world economy? After all the Fed is on the case, and nothing could go wrong when it stands ready to keep interest rates down.

All of this sounds quite plausible, but I don’t buy it.

My reading of the ground realities leaves me reasonably confident that the market will be giving back most if not all of its 2012 gains in the coming year.

Just like this year, professional forecasters have been hoping for a second-half GDP recovery at the start of each of the last three years. But we always had corporate earnings to fall back on when the ‘second-half recovery’ wouldn’t show up. Unfortunately for us, the earnings cycle is over and wouldn’t be available to prop stocks up this year.

I am not making a recession call, though a fall off the ‘cliff’ would do just that. What I am expecting, however, is a far tougher environment for the broader stock market indexes than what we saw in 2012. And while here would still be plenty of profitable investment opportunities in the stock market in 2013, the overall orientation of your portfolio should be defensive. Such a posture may not get you home runs in the market, but you wouldn’t have to lose sleep over your capital either.

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A Critical Look at the Fundamentals

Here are reasons why I find it difficult to buy into the ‘all-is-good’ consensus narrative.

  1. U.S. economy – Stuck in Low Gear: It is hard to say anything positive about the U.S. economy outside of the housing sector. But the housing gains are barely enough to offset the weakness in the factory sector and corporate capital spending. The economy expanded at +3.1% pace in the third quarter, but will barely achieve half that growth pace in the current and following quarters. The consensus expectation is for a second-half growth ramp up again this year, just like it has been looking for at the start of each of the last three years. With some sort of austerity getting underway in any ‘Fiscal Cliff’ resolution scenario, the second-half recovery expectation may be nothing more than just a ‘hope’. It’s good to be hopeful in life, but ‘hope’ shouldn’t form the basis for your investment outlook. 

 

  1. Europe – Together in Sickness: The economic picture is no better beyond the U.S. shores. Europe has made some progress recently in tackling the existential threats to the currency union. That is no small achievement, but the region’s economic fortunes are steadily moving downhill, with the periphery’s problems slowly seeping into the ‘core’, as recent softening data out of Germany bears out. While the consensus view is for ‘nor growth’ in the region in 2013, the most likely scenario is for it to remain in recessionary territory.

 

  1. China May Not be Hard Landing, But they Aren’t the Growth Engine either: China’s case is somewhat different relative to the U.S. and Europe since they have the capacity to prop their economy. Recent trade, industrial production, and electricity generation data shows that the deceleration trend may have started easing already. But while the ‘hard landing scenario’ may no longer be the base-case outcome, the double-digit GDP growth rates of years past may not be coming back either. In fact, it is hard to envision the country sustaining GDP growth in the 7% to 8% vicinity without domestic consumption becoming a bigger piece of the economy and given the growth outlook for Europe and the U.S.

 

  1. Corporate Earnings – ‘Hoping for the Best’: If you thought the third-quarter earnings season was weak, wait till you see the coming earnings season. With just days to go before the fourth quarter reporting season gets underway, estimates have dropped from the roughly 8% expected growth a couple of months back to barely in the positive territory. Expectations are for a turnaround in 2013, with total earnings up close to 11% on top of the roughly 5% growth this year. Count me as skeptical of these forecasts. With margins already peaked out and growth a problem all over the world, these expectations may not be much different than ‘hoping for the best’.

Making It Work for You

This may not sound very uplifting, but there are always profitable investment opportunities even when the broader stock market indexes are in the red. You don’t need to do rapid-fire trading to take advantage of those opportunities, but your odds of coming out ahead increase significantly should you reposition your portfolio ahead of time.

Each year, we combine the top-down approach explained here with a rigorous bottom-up stock selection process to come up with our ‘Zacks Top 10 Stocks’ portfolio. In 2012, we had a phenomenal +29.3% return through the end of November, way ahead of the +11.1% performance of the S&P 500 index. We are about to come out with the Zacks Top 10 Stocks for 2013. There is obviously no guarantee that we will be able to repeat our past outperformance in the coming year, but having a robust framework in place puts the odds in our favor.

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Thanks and prosperous trading,

Sheraz Mian

Sheraz Mian is the Director of Research. He determines which valuable data to use to assess winning stocks and funds. He is a contributor for Zacks Equity Research and Earnings Analysis, and is also the editor of Zacks Top 10 for 2013 report.

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