Tags: Barclays, Credit Derivatives Research, Dow Jones Industrial Average, Nasdaq Composite Index, Proctor & Gamble, Russell 2000, U.S. Stocks

High-Quality Stocks Ready to Take the Lead in the U.S. Market

By , Contributing Writer, Money Morning •

With the major U.S. stock market indices trading at recent highs, there is new evidence that the most recent phase of the advance was fueled by the lowest-quality stocks. But now it looks like higher-quality companies may be ready to take the lead: These shares will emerge from their slumber, causing the Standard & Poor’s 500 Index to advance by as much as 12.5% from current levels.

Let’s take a look at the big picture.

U.S. stocks weren't scared by a quadruple-witching session on Friday as some of the market's multi-month laggards pushed the indexes to another round of new highs. The Dow Jones Industrial Average gained 0.4%, the S&P gained 0.3%, the tech-laden Nasdaq Composite Index gained 0.3%, and the Russell 2000 gained 0.4%.

Normally, we expect much more volatility as traders try to push stocks around to maximize the value of their options contracts. It's typically a battle as the big Wall Street banks work to dampen price movements to make sure the maximum numbers of derivatives end up worthless. But this time the key battle of the quarter was over tens of billions of dollars worth of S&P 500 “put" contracts that bears had written earlier in the summer with the expectation that the big-cap U.S. stock index would finish lower this month.

The contracts ended up so far out of the money – burning a huge amount of bears' capital – that there just wasn't that much to fight about. Bears' resources are more depleted now, so the expectation will be that they won't have the ammo or courage to be as bold going into the rest of this month and next quarter.

The news flow was light Friday with no new economic releases. We did see some fireworks early in the day as the bears targeted smaller, high-beta stocks however. As a result, all the major indices except the Dow dipped into the red before bulls counterattacked. In the end, it was the ninth positive finish out of the last 11 trading days, a performance that matches the rapid rise last witnessed in July.

At the sector level, consumer staples were the best performers as the Staples Select SPDR (NYSE: XLP) climbed 1.3% thanks to a 3.2% rise in The Procter & Gamble Co. (NYSE: PG). The great – but beaten-down – maker of toothpaste, toilet paper, and laundry detergent was the Dow's best performer. Laggards on Friday included energy, healthcare, and industrial stocks.

Volume increased dramatically as 2.3 billion shares traded on the New York Stock Exchange (NYSE: NYX). This was a level of activity we haven't seen since June. It was caused in large part by quarterly rebalancing of the indices maintained by Standard & Poor's as mutual funds and other institutional investors adjusted their portfolios to account for the shifts.

Trading technology provider Investment Technology Group (NYSE: ITG) estimates that some $900 million in consumer stocks and $860 million in financial stocks were purchased as a result of the rebalancing. Sales were forecasted at $650 million for the energy sector and $517 million for the healthcare sector. Overall, these transactions explain much of the individual stock movement we saw on Friday.

Technically, stocks are overbought on a short- to medium-term basis as they cruise towards heavy resistance at 1,121 on the S&P 500. While this condition doesn't preclude additional gains, it is a caution light that reminds us to fight the urge to become complacent or overly aggressive. This observation is based on a number of indicators I monitor, including the percentage of stocks over their 10-day and 50-day moving averages, price oscillators, and distance between index prices and their 200-day long-term moving average.

Allow me to elaborate on that last indicator. Currently, the S&P 500 is at 1,068.30 – 16.5% away from its 200-day moving average of 892. This is the highest reading in 23 years. Out of the 15,025 trading sessions since 1950, a momentum explosion of this magnitude has only occurred for a grand total of 44 days. That's just 0.3% of the time.

The most prominent examples occurred in the summer of 1975 and the fall of 1982. In both cases, like now, the economy was pulling itself out of nasty, consumer-focused recessions. The divergence stayed about 10% for nine months between 1982-1983, but only lasted for three months in 1975 – before some consolidation ended the string of gains. The divergence reappeared for a few months in early 1976.

These two events occurred within the context of rallies that took the S&P 500 to trough-to-peak gains of 73%. Both of these historical examples were followed by sizable corrections. From 1983 to 1984 the S&P 500 lost 15%, before turning around and resuming its climb. Between 1976 and 1978 the loss totaled 24%.

Here's where we are now: This extreme divergence between the index's current value and its 200-day average has been in place for just two months. And since the March low, stocks have gone on to gain 61%. If our current situation follows history's roadmap, then we could see additional gains of at least 8% as the S&P 500 confronts resistance at 1,121.

Such a breakthrough would take many by surprise and put the 1,200 level in play for a total gain of 12.4% from here. At that point, sentiment would likely become more bullish, and we would look to hunker down and protect capital. It would be at this point that traders would punish stocks should the recovery prove less robust than is currently expected. According to Gluskin Sheff + Associates Inc.Chief Economist David Rosenberg, stocks are pricing in 4% U.S. gross domestic product (GDP) growth next year. If that's correct, then anything less, no matter if it's as high as 3.5%, would amount to a disappointment.

So that's our intermediate-term view: The recent extreme strength is more of an indication of powerful bull-cycle initiation, as seen twice before in the past 35 years, than a surplus of optimism likely to be immediately and profoundly reversed.

Short-term, the days following September options expiration have been quite bearish over the last few years with the Dow down five years in a row between 2002 and 2006. That could easily happen again now. And then just as fear wafts over Wall Street like an acid fog in advance of October, my expectation is that the high-quality stock rotation I mentioned will take place. That will move the Standard & Poor’s 500 Index toward the 1,121 to 1,200 range, for a return of as much as 12.5%.

Keep in mind that third-quarter earnings season is coming up in two weeks, and expectations remain poor. Some positive surprises in retail, banking, tech and heavy industrials are likely to provide the fundamental underpinnings. Keep in mind that companies are coming up against some of the lowest earnings comparisons in decades, since last summer was so bad for business. Stay positive.

Quality Makes a Comeback

The big advance of Procter & Gamble on Friday may be an early highlight.

Some of this has been caused by a scramble into the riskiest holdings on fear of missing out on the rally and a desire to maximize exposure to the broad market. Short covering has played a role too as many of the best performers this summer were among the most heavily shorted names.

Matthew Rothman of Barclays Capital (NYSE ADR: BCS), who maintains a variety of quantitative stock indices, including one that focuses on quality, reported last week that companies that are considered low risks by bond rating agencies underperformed companies considered high risk for the longest period in 60 years. Rothman said the streak ended on Wednesday and shows signs of turning around.

Other indexes he follows are based on characteristics like market sentiment and valuation. On the phone from New York, Rothman described his Quality Index taking into account things like historical profitability, earnings traits, and balance-sheet structure.

However, there is no clear statistical link between the ending of a period where quality underperformed and any particular prediction on the direction of stocks in general or high quality issues in particular. So it is certainly possible that high quality stocks take over for low quality names and power the market even higher from here.

Personally, I vote for this option. Rotation is a beautiful thing, as it allows markets to move forward without overextending. Think back to all those major stocks I showed you last week that have done nothing this year –Procter & Gamble Co., AT&T Inc. (NYSE: T), McDonald’s Corp. (NYSE: MCD), Exxon Mobil Corp. (NYSE: XOM), Chevron Corp. (NYSE: CVX), and Wal-Mart Stores Inc. (NYSE: WMT). If those guys can get moving now, they can take the capitalization-weighted indexes back to that 1,200 level without a lot of trouble. .

A similar story is being told in the credit markets. Dave Klein of Credit Derivatives Research finds that high-beta companies are performing best in the credit default swaps market. Fully 80% of the names Klein tracks are now trading with their credit default swaps lower than what his models predict – suggesting investors have dramatically lowered their default expectations over the last few weeks.

This could mean one of two things: Either institutional investors are becoming more optimistic or they've become more complacent. In any event, we still continue to monitor these metrics closely for signs of risk aversion being on the rise. It won't mean that the uptrend is ending, only that it will move into a more mature and slower paced phase. Which is fine with me.

Week in review

Monday: The high-beta trade was on in a big way as cyclical transportation and materials stocks found eager buyers. Janet Yellen, president of the Federal Reserve Bank of San Francisco, spoke to a group of financial analysts. The good news is that she was "happy to report that the downturn has probably run its course."

The bad news was that she went on to say that the recovery would be "tepid," as consumers remain under pressures and credit losses mount. She pointed out the fiscal boost consumers are currently receiving from the government, which has helped bolster spending, it nearing its end. You can see this in the chart above, courtesy of Deutsche Bank AG (NYSE: DB). There is a risk that, as tax rebates and transfer spending tapers off, consumers could retrench at the worst possible time: In the midst of the holiday shopping season.

Tuesday: U.S. Federal Reserve Chairman Ben S. Bernanke declared that the recession is "probably over" from a technical perspective. Retail sales jumped 2.7% in August – the largest increase in three years, thanks to the Car Allowance Rebate System, better known as the "Cash-for-Clunkers" program. Producer prices suggest inflation continues to moderate, leaving central bankers with plenty of leeway as they nurse the economy back to health.

The Empire State Manufacturing survey provided more evidence that the manufacturing sector is turning around on an increase in new orders. An increase in delivery time adds credence to our thesis that businesses are waiting until the last possible moment to increase production and hire workers back – an unsustainable condition that could result in a hiring frenzy as production managers scramble to reduce order backlogs.

Wednesday:

It was a big day for corporate behemoth General Electric Co. (NYSE: GE) as its stock rose 6.3% -- pushing the entire conglomerate sector higher. Industrial Production rose 0.8% in August as capacity utilization increased to 69.6% from 68.5% as more factories spool up. This was the second monthly gain in a row and represents the first real signs of life from the manufacturing sector since the recession began back in 2007.

Thursday: The Philadelphia Fed survey of business activity rose smartly to 14.1 in September from 4.2 in previously. This is the best level since June 2007 – six months before the recession even started. Jobless claims improved slightly, falling 12,000 to 545,000. But the raw, non-seasonally adjusted data was even better as it showed a big plunge from 466,000 to 408,000. Single-family housing starts fell slightly as the home market continues to feel out a bottom. Housing permits were up 2.7%, however, which is a positive sign home construction could actually add to GDP growth in the latter half of the year.

The week ahead

Monday: The Conference Board releases its index of leading economic indicators for August. The index gained 0.6% last month thanks to increased stocks prices and rising consumer confidence. Consensus estimate stands at 0.7%.

Tuesday: The Federal Housing Finance Agency reports home price data gathered from Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). The Federal Reserve begins its two-day policy meeting.

Wednesday: The Federal Reserve will announce its interest rate decision. Watch for an update on its initiative to directly purchase U.S. Treasury debt. As we've said before, the initial $300 billion allocation is nearly exhausted. I don't expect any increase in the Fed Funds rate for at least six months, and more likely a year or more.

Thursday: We get an update on existing home sales. Sales jumped 7.2% in July as sales moved to their highest level since early 2007 thanks to the government's $8,000 first-time home buyer tax credit. Senator Isakson from Georgia, a Republican, has proposed a bill to increase the credit to $15,000 and make it available to everyone.  

Friday: Updates on durable goods orders, consumer sentiment, and new home sales.

Our Recommendations: Prepare for a change in the tone of the advance, as larger, higher-quality, slower moving companies begin to awaken from their slumber and take over the lead from their smaller, lower-quality, faster-moving cousins.

[Editor’s Note:New Money Morning contributor Jon Markman is a veteran portfolio manager, commentator and author. Anthony Mirhaydari was the research assistant on this column. Markman currently serves as the editor of two investment-research services, Strategic Advantage and Trader’s Advantage. For information on obtaining a two-week free trial to the daily commentary of the Strategic Advantage, please click here.]

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