Eight Stocks for the Market's Next Rally

09/10/2010 9:03 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

Looking at which stocks made big moves in the market's September 1 jump shows us where to be when the market turns for good. Here are eight picks for your watch list.

Think of the huge jump in stocks September 1 as a dry run for the eventual stock market rally.

I don't think that rally is here yet. I think the move last week was a bounce, a very welcome bounce, but still a bounce, as the extreme pessimism of the end of August swings to something like only mild pessimism. Investors had a chance to think about the course of the market over Labor Day weekend and returned in a selling mood on Tuesday.

As we have been for most of summer, I think we're still in a range-bound market, with a top near 1,130 for the Standard & Poor's 500 Index. But we're seeing positive signs that the market is getting ready for a sustainable move above that range. The September 1 rally began from a level above the July low. Rallies begin when stocks start posting higher lows, so I'm guardedly hopeful about stocks as we head into the fall.

But can I tell you that the stock market has bottomed? Can I guarantee that it's all up from here? No way. I don't know that even after the big move of September 1.

What I do know after the September 1 jump is what kind of stocks are most likely to outperform if the market stages any sustained rally. And therefore, I know which kind of stocks you should look to accumulate in the fall if you think the market is moving toward a sustained rally. (Most probably it would be after the November elections.)

Finding the Outperformers

Not surprisingly, the best performers September 1 were those stocks where worries about global economic growth had weighed most heavily in July and August.

But I think we can go a bit further than that terribly vague observation. To get ready for a rally in the last quarter of the year (or so), I'd also look for the stocks of companies where the swing in revenue and earnings will be particularly pronounced if the global economy grows with even modest strength.

And I'd look especially for stocks with those characteristics that are, in addition, commonly thought of as particularly risky because of their industry and/or their exposure to emerging markets.

Let me give you some examples that popped out at me after September 1. You may not want to buy these specific stocks (now or perhaps ever), but they certainly are good pointers to the sectors and stocks that you do want to buy.

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For a stock to get my attention in the September 1 rally, it needed a jump that was way above the 3% gain recorded by the S&P 500 that day.

The best performers in US markets fell into very identifiable groups. As you might expect, some of the big winners were in the truly beaten-down sectors and industries:

  • Among homebuilders, KB Home (NYSE: KBH) was up 11.1%, Beazer Homes (NYSE: BZH) 9.5%, and Hovnanian Enterprises (NYSE: HOV) 7.6%. Shares of companies that depend on the health of the homebuilders also gained; Lumber Liquidators (NYSE: LL), for example, gained 7.1%.

  • Among oil drillers, Rowan (NYSE: RDC) climbed 9%; Pride International (NYSE: PDE) was up 7%

The rally also helped a few stocks in special situations, such as Burger King (NYSE: BKC), which jumped after a buyout offer from a Brazilian investment fund.

These patterns are interesting, but I don't find them compelling. In most of these cases, the stocks that popped in these groups are companies still fighting huge headwinds. Fixing the problems of oversupply in the housing industry, for example, isn't a matter of just a good quarter or two.

But also among the best performers—and this is where I'd say the most interesting action was September 1—was the cyclical group, the stocks of companies heavily leveraged to the economic cycle. Cyclical stocks are historically one of the sectors that rise fastest when the economy recovers. If investors were expressing a little more optimism about the economy September 1, it's exactly these stocks that should have soared.

And that they did suggests you'd like to be overweight this sector when the real turn in the economy arrives.

Cyclical Strength

What were some of the best-performing US cyclical stocks September 1? Let me give you a short list:

  • Cummins (NYSE: CMI), a maker of truck engines, up 7.4%

  • Titan International (NYSE: TWI), a maker of tires for construction, mining, and agriculture, up 7%

  • Massey Energy (NYSE: MEE) and Walter Energy (NYSE: WLT), two coal companies, up 7% and 7.1%, respectively

  • Bucyrus International (NYSE: BUCY) and Joy Global (Nasdaq: JOYG), makers of mining machinery, up 7.9% and 6.1%, respectively

  • Rio Tinto (NYSE: RTP), a diversified mining company, up 7.3%

  • And DryShips (Nasdaq: DRYS), an ocean carrier of bulk cargoes, up 7.7%

I think you get the idea. Why these companies?

Because, by and large, they fit into a category that I've flagged for you more than once in the past few months (most recently in my blog post "If the economy is so terrible, why are machinery stocks relatively strong?").

This group is defined by this rule of thumb: The longer the lead time of your customers and their business—the longer, for example, it takes them to increase production—the more likely those customers are to start buying now.

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For example, in its recent earnings report for the quarter that ended in July, Joy Global said it was seeing stronger-than-projected orders from its customers in the mining industry. Instead of orders growing by 25% in 2010, the company was projecting 30% growth. And 10% growth for 2011.

That's not because the mining companies that are Joy Global's customers are run by wide-eyed optimists who see the US and global economies going into a boom cycle in the next quarter or two. I think that in the short term, the CEOs of these customer companies are as worried about the economy as everyone else, from Wall Street to Main Street.

It's that these customer companies can't think just a quarter or two ahead. A new mine can easily take five years to get into significant production. In the same way, a trucking company can't wait until the August trade fairs to order for the holiday shopping season, as some retail consumer companies can. Orders for new trucks have to be placed a few quarters in advance.

Can't Afford to Wait

Customer companies in these industries remember all too well the kinds of shortages that hamstring them at the top of the cycle in their respective industries. Oil sands companies can't increase production because they can't get tires for their big earthmovers, for example. If you've been through that recently, you may not want to build up huge inventories of tires, but you are inclined to err on the side of ordering what you need early before shortages materialize.

These companies also know that since the last boom, suppliers have cut capacity, merged, or gone out of business. The boom cycle, whenever it comes, will confront a supply chain that has fewer suppliers with less capacity and that are possibly farther away. It's only logical to hedge your bets by ordering early.

Early orders don't have to turn into actual sales. Companies can prepare for better days that never come. Or better days could simply be further away than these CEOs think right now.

But if the economy turns, if we get evidence that the better days—even if they're only "better" and not "good"—are upon us, then, thanks to the September 1 dry run at a rally, we know which stocks will outperform.
Under the circumstances, a risk-averse investor, might—instead of sitting totally in cash on the sidelines—start building a position or two in some of the soundest of these companies. Cummins and Joy Global come to mind. The former is in Jubak's Picks, and the other is in my long-term Jubak Picks 50 Portfolio.

You don't have to rush out and buy them immediately. I think we've got a long, volatile September ahead of us. But you should be thinking about them and other cyclical stocks to buy on the day that you become convinced that the economy isn't falling off a cliff.

I think that day may be closer than the macro numbers indicate. In Tuesday’s column, I'll write on why anecdotal evidence indicates what may be surprising strength in the US economy.

At the time of publication, Jim Jubak did not own shares of any company mentioned in this post in his personal portfolio.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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