3 buys for this sideways market--and more thoughts on the "New Paranormal"

05/18/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

“A secular sideways market.”

That’s the best succinct description that I’ve heard so far of the stock market we’re in. It comes from Jack Ablin, chief investment officer at Harris Private Bank, at a panel that we shared at the recent Las Vegas MoneyShow.

At the same conference, Sam Stovall, the chief equity strategist for Standard & Poor’s Capital IQ Equity Research Department on another panel I had the privilege of sharing, peered into his crystal ball and offered that the gain on the S&P 500 would be about 4% in 2012. With lots of volatility—so much so that this year, Stovall told Bloomberg, that a 5% move should just be considered “noise.”

It’s reassuring to me these two smart market analysts see something like what I’ve called the “New Paranormal” market http://jubakpicks.com/ in my March 2 post. In my paradigm that market is characterized by lots of volatility but not much net gain—Ablin’s “sideways”—and achieving an annual return of 5%--Stovall’s 4% for 2012—should be considered a major achievement. This is still a paradigm under construction (and I’ll post a link for you to get a copy of its latest revision from the MoneyShow on May 16 on my http://jubakpicks.com/ site in the next few days.)

But watching the market action and listening to investor sentiment over the last few days has already suggested a new element to add to the model. It’s what I’m calling the Dangers of Deflationary Investor Sentiment. And I think it’s a major obstacle to achieving even the 4% to 5% returns that characterize a secular sideways market.

So let me start by telling you what this is, why it’s dangerous, and what to do about it. (Along with a few stock picks for execution during this current sell off.)

The easiest way to describe Deflationary Investor Sentiment is to use Apple (AAPL) as an example.

Not so long ago, on May 11 to be precise, I wrote a post on careful bargain hunting http://jubakpicks.com/2012/05/11/buy-on-the-dip-in-this-market-carefully-very-carefully-but-the-bargains-are-out-there/ and suggested that Apple was a buy when it dropped to $560 or lower. That would be a substantial 13% decline from the stock’s $644 intraday high on April 10.

The shares closed at $558 on May 14. Did you buy?

And at $546 on May 16. Did you buy?

How about yesterday when hedge fund managers apparently all decided over breakfast to take profits and the stock fell almost 3% to $530?

If you didn’t buy, and obviously most investors didn’t or otherwise the stock wouldn’t have continued its descent, the most likely reason is Deflationary Investor Sentiment. You didn’t buy on May 17 at $530—even though Apple shares were down 17.7% from the $644 high—because you thought that by waiting, you’d get the stock more cheaply in the future.

This is classic deflationary thinking of the kind that we’re familiar with from Japan in that economy’s lost decades. In Japan’s deflation consumers put off purchases—a car, a new futon, a new Sony TV—because they believed, usually correctly, that these goods would be cheaper tomorrow. Deflationary psychology forms a self-fulfilling prophecy since less current buying means less demand means price cuts as companies try to jump start demand.

I think you can find the same thinking in the stock market right now. I won’t buy Apple at $560 because I believe I can get the shares at $530 tomorrow. And now that the stock is at $530, I’ll hold off buying because I’m waiting for $520 tomorrow.

Despite the similarity in psychology, however, between economic deflation and stock market deflation, there is a major difference—the speed of any potential reversal.

Economic deflation is notoriously hard to reverse, which is why central bankers such as Federal Reserve chairman Ben Bernanke is so determined to keep it from taking root in the United States economy.

Stock market deflation can be sticky. Looking at the Apple chart it’s easy to see why an investor might decide to wait until the shares were closer to the 200-day moving average at $457 before buying.

But unlike economic deflation where it pretty much takes a change in the purchasing psychology of a nation to reverse course, in the stock market all it takes is buying by a significant minority to reverse the direction of prices. That’s because once prices start to move up another powerful investor emotion begins to kick in—we don’t want to be left behind in a rally and so we buy because prices are moving up just in the same way that we sold when prices were falling because prices were falling.

The more volatile a stock market is—and remember this one is very volatile—the more danger there is to your portfolio in this move into and out of stock deflation. If an investor not only sells because everybody else is selling but delays buying until everybody else is buying then you’ve got a formula for buying high and selling low over and over again.

And the more susceptible you are to the fears of stock market deflation, the more damage that this kind of market is apt to do to your portfolio. If a stock market decline makes you one of the last to buy back in—because you’ve become extremely sensitive to taking another loss—then you’ve set yourself up to be one of those investors that everyone wants to sell to when a stock is near a peak.

There’s no foolproof way to either avoid buying too early—Apple could after all continue to fall from here—or to avoid holding on too long.  But you definitely want to avoid becoming a stock market cynic—someone who knows the price of everything and the value of nothing—because that leaves your investing strategy total at the mercy of short-term volatility in a very volatile market.

Apply this to Apple.

Here’s a stock that trades at 13 times trailing 12-month earnings per share and at 11 times projected fiscal 2012 earnings per share. Wall Street projects that earnings will grow by 69.6% in the fiscal year that ends in September. That puts the PEG ratio (PE to growth rate) at a very attractive 0.54. Even if Wall Street is right and earnings growth for Apple drops to 15% in fiscal 2013 (and I think that’s wrong), this is still very reasonably valued stock.

And this is all before we’ve factored in Apple’s $100 billion in cash. Include that and the PE for this stock drops to 11 times trailing 12-month earnings.

So yes, this market is volatile enough so that Apple could drop to $457 and then you’d be looking at a 14% loss from a purchase at $530. But this market is also volatile enough so that some piece of macroeconomic news—an announcement from the European Central Bank that it will resume buying Spanish and Italian government bonds—could turn sentiment from deflation to inflation, so to speak.

That could certainly change the price of Apple—although I don’t think it would change the value of Apple any more than the profit taking by hedge funds that has driven the price down has changed the value of Apple.

I’ll be adding Apple to Jubak’s Picks today because I find $530 compelling value.

I’ll also be adding shares of Schlumberger (SLB), which closed at $64.75 on May 17 (and therefore in my buying range of $64 to $65), and McDonald’s (MCD), which closed at $89.62 (and therefore below my buying target of $93).

I’ll be posting explanations of why I like those stocks later today and I’ll be making some sells in the portfolio as well to make sure I don’t get too concentrated in any sector.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple and Schlumberger as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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