Hot List: Familiar Faces, Familiar Trends

In the latest issue of the Validea Hot List newsletter, John Reese says his models are again picking up some stocks they’d been keen on earlier in the year, and says he’s seeing signs of a market returning to normalcy. That’s not to say that all’s well, he adds, but it does appear that the market — as it always has — is fighting back against the recent crisis with some success. Here’s an excerpt from the newsletter:

Taken from the July 10, 2009 issue of The Validea Hot List

It’s not unusual for previous Hot List stocks to be sold off and then re-enter the portfolio, though it’s a bit unusual for all four of the stocks to be recent Hot List veterans. I think that’s a good sign, though. Had these stocks left the portfolio because of deteriorating financials, it might have been a sign of a weakening economy. But it appears the reason behind their departures and returns were due to price, not any deterioration of their businesses. Their price gains earlier this year had made them less attractive values than some other stocks in the market, so the Hot List sold them. Now, during this recent minor pullback, their prices have come down to the point that the Hot List again sees strong potential in them.

Capitalizing on what are essentially inefficiencies in the market is exactly what the Hot List is designed to do. And while the overall guru-based system I use is a long-term one, this week’s trades show that these strategies are also quite effective in taking advantage of inefficiencies in pricing over short-term periods.

Perhaps more importantly, the fact that we’re seeing this sort of pattern in the market — undervalued stocks gaining momentum, becoming less attractive values, falling back, and again becoming undervalued — is a good sign. Last year’s bursting of the equity bubble left stocks plummeting indiscriminately with no real sense of value. This year, particularly in the past few months, we’re seeing signs that stocks are settling back into their usual patterns of short-term fluctuations — and that means opportunities for investors.

Along the same lines, 2009 has also seen a return to discrimination among different types of stocks. Last year, just about every industry was in the red, and the best-performing sectors still lost close to 20%. So far this year, according to Morningstar, 22 industries are up more than 30%, while 21 are down more than 20%. In the style-box categories — all of which were way down, within a fairly tight range, last year — there’s also been discrimination, with the results ranging from +10.6% to -9.9%.

Now, discrimination among sectors, industries, styles, and size doesn’t mean all is well in the market, and, even within the first half of this year, investors tastes have swung pretty substantially (going from growth-focused in the first few months to value-focused in the last few, for example). But taken with some other signs, this discrimination starts to paint a picture of a market that is at least in the early stages of settling back into a more “normal” state. For example, in the past few months, we’ve seen value stocks roar back after a lengthy period of underperformance, just as they always have. And we’ve seen the market turn just after investor sentiment was reaching extreme lows, as it usually does.

In addition, there has been a marked drop in volatility over the past month or two. The Chicago Board of Options Exchange Volatility Index (the VIX) has spent most of May, June, and July hovering in the high 20s and low 30s, its lowest level since before last fall’s financial meltdown. (It actually climbed over 80 in the fall.)

Taken together, the value rebound, low-sentiment rebound (and subsequent higher-sentiment pullback), and dramatic decrease in volatility are signs of a market that is following historical trends, and showing signs of stabilization. Does that mean we’re out of the woods yet? Of course not. Major issues remain with the economy, the stimulus plan (and, potentially, second stimulus plan) will have repercussions, and, in the shorter term, the upcoming round of earnings announcements will no doubt have a big impact on the market’s direction. But the signs I mentioned above do indicate that the market is both battling back from serious troubles with some success, and exhibiting some of the behaviors and trends it has in the past — it hasn’t morphed into some completely new animal, as some feared it would.

Whatever the short term brings, I believe that over the long run, the market will continue to stabilize and function, in a broad sense, as it always has, rewarding patient, long-term, disciplined investors. And that means that valuations will remain key to posting good returns. Right now, both the broader market and individual stocks remain attractive. At the end of the second quarter, the 10-year price/earnings ratio of the S&P 500 was 15.75, which was still slightly below its long-term average. And James O’Shaughnessy notes that 15% of stocks in the index were trading below liquidation value toward the end of the quarter. The U.S. markets are also attractively valued compared to those of other nations. In late June, the U.S. had the eighth-lowest current P/E ratio of 20 major countries, at 14, according to Bespoke Investment Group. (The average for the 20 countries was 20.15.)

Individual stocks look even better. Each of the firms added to the Hot List this week gets approval from three of my best-performing long-term strategies — those I base on the writings of Benjamin Graham, Kenneth Fisher, and Peter Lynch. They have strong balance sheets and impressive fundamentals, and by focusing on those types of well-rounded stocks, I expect the portfolio will continue to take advantage of the opportunities the market gives it and post some strong gains over the long haul.