Ready to Ride a Cyclical Bull


By Gene Marcial Even as the market continues to defy prognostications of all sorts, some savvy Street pros -- known for their extensive research and long investment experience -- continue to believe that a strong "cyclical bull market," one that would last for three to six months, lies ahead. Among them are the folks at Ned Davis Research Group, including chief investment strategist Ned Davis, chief global strategist Tim Hayes, and Sam Burns, senior equities analyst. The major clients of Ned Davis Research, which is purely a research outfit, are institutional investors and experienced market players.

Davis and his team don't deny that Wall Street is still in the throes of a long-term secular bear market. But they make the case that a short-term, cyclical, bull is just around the bend. A number of indicators confirm this, they argue, including monetary measures, the behavior of stocks based on moving averages, advances and declines, new highs and new lows, and advancing and declining volume.

Ned Davis Research expects this projected interim bull market to produce hefty gains of 30% to 35% in the Standard & Poor's 500-stock index, which opened on July 9 at 976.66.

A TIME FOR STOCKS. The firm's view is reflected in its recommended asset allocation: 65% in stocks, representing a 10% overweighting in its historic stock-allocation norm, and 35% in bonds. Ned Davis suggests zero allocated to cash.

In a nutshell, Davis contends that the market uptrend that began on Sept. 21, 2001, is still intact. The allocation mix, he says, recognizes the historical tendencies of investment performance in the current post-recession and pretightening phase of the economic cycle. With inflation low, bonds can hold their own, notes Davis. "But the improving economic and profit outlook is more conducive to strength in stocks than in bonds," he adds.

If a cyclical bull market does emerge, as Davis and Hayes are forecasting, which groups are likely to assume market leadership? Hayes believes that shares of consumer-products companies that depend on discretionary spending, as well as the industrial and basic-material companies, will lead the advance.

TOP PICKS. In terms of which groups should be favored now between the growth and value stocks, Davis' firm favors value stocks over growth equities -- "and we continue to side with small-caps over large caps," says Davis.

Sam Burns says in terms of individual stock picks, Ned Davis Research ranks companies mainly on the basis of momentum in stock-price gains, positive earnings revisions, and the strength of the industry they're in.

On top of their list: Three household-products makers, Church & Dwight (CHD), Dial (DL), and Clorox (CLX); Constellation Brands Cl. A (STZ), a wine and beverage company; Bob Evans Farms (BOBE), a restaurant chain; Procter & Gamble (PG), a major household- and consumer-goods company; CBRL Group (CBRL) a restaurant chain; Ryder Systems (R), a transport and trucking company; and Krispy Kreme Doughnuts (KKD).

"FRIENDLY" FED. The fundamental case for a cyclical bull market, says Davis, "is summed up in the record level of stimulus we have seen in the past 12 months -- from a combination of fiscal, monetary, and exchange-rate policies." Despite such moves, inflation hasn't been a problem, "thus allowing the Federal Reserve Board to remain friendly" and keep interest rates low.

Davis says he believes that the U.S. economic recovery is still on track, "though the high levels of debt and high bond yields will lead to a less-than-ideal recovery." In particular, he expects a "good rise from the manufacturing sector and a nice pop in profits" from a year ago.

What should investors watch to know that a strong bull market is under way? Davis says one good sign is when stocks trading on the New York Stock Exchange are above their 10-week moving averages: Once this indicator rises above 90% (it's now below 70%), the market historically rises with an average 12-month gain of 19.8%, says Davis.

TOO PESSIMISTIC? Tim Hayes notes that indexes that track growth stocks as well as the Nasdaq composite index continue to languish in a bear market. He blames investor pessimism toward these groups, due in part to the steady stream of negative news on corporate reporting and accounting practices.

But he notes that outside the growth and Nasdaq sectors, the average stocks, including value-oriented shares, have held up quite well. He thinks the broad market remains in the bull phase that started last September. About 6,700 stocks are in Ned Davis Research's database, in which the median stock dropped by just 8% from Mar. 19, 2002, the day the S&P 500 hit its recent high. Such a modest decline represents to Hayes only a "correction." Compare that, he says, to the median stock's drop of 31% during the 2000-01 bear market.

A BOTTOM? Hayes also studies the quality and quantity of volume of shares traded. Indications are that the volume trend has improved -- but not enough to convince him that the market has actually hit bottom. That process starts wth an extremely high ratio of declining volume to advancing volume, says Hayes -- similar to what happened in the Dow industrials' initial low in 1990.

Still, perhaps what all these complex indicators and long history prove is that the stock market is one mysterious -- almost unfathomable -- organism. Marcial is BusinessWeek's Inside Wall Street columnist


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