Profiting in Market's Stormy Weather

2001 was a wildly frustrating year for stock market investors.

A second-consecutive year of negative returns aggravated market bulls. The losses were not significant enough to educate and reform the perma-bulls, but listening to their relentlessly optimistic drone has irritated even the most faithful. The significant rally in the fourth quarter raised hopes yet again that happy days are here again.

On the other hand, the lack of a complete stock market collapse (especially after Sept. 11 and the implosion of corporate profits) continues to frustrate the bears. Still-lofty stock valuations and the incessant hype spewed by reporters, analysts and portfolio managers on CNBC tainted the bears' "victory" earlier in the year. Both bears and bulls remain frustrated with Alan Greenspan, the former for his New Economy boot-licking, and the latter for his stock market bubble-pricking.

Familiar-Sounding Forecast

I predict that 2002 will bring more of the same, unfortunately. Violent sector rotation will continue to foil momentum investors. High valuations will confound value investors. The lack of legitimate, secular revenue and profit growth will thwart growth investors. Total returns for the major indices this year should be modest profits or moderate losses in a grinding, rotational market environment.

Stock prices will be supported by the Pavlovian response to lavish liquidity as well as by a stubborn belief in a strong economic and profit recovery during the year's second half. Earnings expectations have been set so low by devious corporate managements that they may be raised through the first half. "Raising expectations" might become the talking heads' newest buzz phrase.

The chart monkeys and mo-mo investors can turn positive surprises and attractive charts into pretty powerful rallies. But eventually, any market rally will run smack into the wall of high valuations, technical resistance and maybe even insider/corporate supply. The real surprise of 2002 might be the IPO calendar, not because investors clamor for new shares, but because companies have to sell shares.

Another obstacle to a sustainable new bull market will be the duration and magnitude of the economic recovery. While the economy will stop contracting this year, the recovery should be halting and muted. Capacity-utilization rates are much too low to require a significant bump in capital expenditures and much too low to support a major recovery in profit margins. High consumer debt and employment insecurity levels will prevent a rousing resumption of consumption. Disappointing growth in profits will prevent the market rallies from sticking.

Lessons From 2001

How can investors profit in what will probably be a difficult market environment? Buy low-valuation shares of solid companies after overreaction-driven declines. Sell highly valued stocks, especially ones that strongly participate in market rallies. This strategy has proved lucrative in 2001.

My Oct. 12 column discussed six cheap stocks that fit the above criteria. As a portfolio, they have appreciated 28%, and three names -- Tommy Hilfiger (TOM), Sybase (SY) and Cendant (CD) -- have risen more than 40%! I might harvest some of these positions soon.

My Nov. 12 column recommended five stocks that have risen 13.5% on average, including a 25% move in Sensient Technologies(SXT). Led by a significant trade in a small-cap tech stock, SeeBeyond(SBYN), my portfolio appreciated 25.2% last year. Good stock selection can frequently overcome vain attempts at market timing.

Because of the stock market's current rally, few companies fit my buy discipline. Small- and mid-cap stocks still trade at deep valuation discounts vs. the large-cap sector. From my prior recommendations, I would still encourage purchases in HealthSouth(HRC) and Healthnet (HNT). Both stocks trade for about 11 times my cash earnings forecast for 2002. Investors will rotate back to health care if corporate profitability disappoints.

The market frequently provides obscure small-company turnaround ideas with excellent risk/reward opportunities. Dave and Buster's (DAB) is one example. This entertainment/restaurant company trades for four to six times normalized earnings and 50% of book value. If the economic recovery turns out to be stronger than I expect, a little DAB will do me!

Investment success in 2002 will require prudence, discipline, patience and contrarianism. Trading a churning market with a value bias should provide respectable opportunities at double-digit portfolio returns. It won't be easy.

On the other hand, the far more common habits of ignorance, greed and complacency -- which worked marvelously in 1998 and 1999 -- will fail as they did in 2000 and 2001, completing a hat trick of poor-performance years for most investors. Hey, what can I say? Payback's a drag.

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