Don't give up on stocks

Sure, sentiment is in the tank, but here are a few reasons to start looking for bargains.

By Anthony Mirhaydari Aug 27, 2010 1:05PM

MirhaydariWith equities down more than 13% from their April highs and with bonds on a tear, investors are fleeing the stock market. Equities have underperformed bonds in 10 of the past 12 trading days, while the ICI showed equity funds have lost money for 16 straight weeks.

 

You can see this withdrawal of demand in the breadth data. According to the folks at Lowry Research, who have been tracking the supply and demand trends since 1938, their proprietary measure of "buying power" has dropped 34 points since the early August rally high. In comparison, their measure of supply has fallen only 5 points over the same period.

 

Clearly, instead of intense short-selling, the current market malaise is the result of a buyers' strike. But there are still plenty of reasons to believe that the bull market that started back in March 2009 isn't over just yet.

 

For more, let's turn to Merrill Lynch equity strategist David Bianco. In a recent note to clients, he outlined several big reasons people shouldn't give up on stocks:

 

The S&P 500 is not US GDP

In revised growth figures released Friday, it's clear that America's economy slowed dramatically in the second quarter. Growth was revised down to just 1.6% from the 2.4% initial estimate because of a decline in net exports. This has all contributed to the bearish sentiment.

However, foreign sales are becoming an increasingly important part of the overall business of American corporations, with 40% of S&P 500 profits now originating overseas. Compare this with a 16% share of foreign profits back in 1998. Also, foreign sales tend to carry higher profit margins than domestic sales.

 

As a result, the companies in the S&P 500 get the best of both worlds: Ultralow interest rates from the United States and good growth from the emerging-market economies.

 

The consumer is overrated

It's frequently cited that 70% of the U.S. economy is tied to household spending. And with joblessness still a big problem, you don't need a Ph.D. in economics to see how this would be a big drag on overall growth. Yet only 30% of U.S. GDP growth is tied to retail spending, and only 22% is tied to discretionary retail spending -- the kind of purchases that are affected by consumer confidence.

 

Stocks overall are much more exposed to the corporate sector, with 25% of S&P 500 profits coming from business spending on items like machinery and technology.

 

S&P 500 profits benefit from strong commodity prices

High commodity prices, which will likely be helped along by a sliding U.S. dollar, drive 20% of S&P 500 profits. Energy, materials and industrial stocks are all sensitive to growth in the emerging markets via demand for commodities.

 

Corporate profits return to peak 

While the overall economy stalls, corporate profits have already returned to their pre-recession peak. Bianco expects the S&P 500 to achieve record profitability next year, thanks to a combination of low interest rates, low taxes, higher oil prices, and operating efficiencies.


PROFITS

Record-low mortgage rates to support housing

Although home sales took a big tumble in July, Bianco notes that record-low mortgage rates "minimize the risk of severe real-estate deflation and a deflationary second-wave banking crisis." Why? It's because home prices are what matter to banks, and low interest rates and very little new construction help support prices at the expense of GDP growth.

So while the situation looks grim, with stocks extremely oversold and sentiment very negative, long-term growth prospects remain intact. It's time to go bargain hunting.

 

I have my eye on technology stocks, specifically semiconductors. They tend to be the first to move out of an oversold condition. Semiconductor equipment provider Kulicke and Soffa Industries (KLIC) looks particularly attractive at current levels.

 

Disclosure: The author does not own or control a position in any  company mentioned.

 

Be sure to check out Anthony's new investment advisory service, the Edge, which is launching in September. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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