If investors were paying attention last week, they could have seen the kinds of stocks that will do well if inflation really is rekindling. The consumer price index surged ahead at a preliminary but still scary annualized rate of 6% in March. So it's little wonder that the federal funds futures market is now giving even odds for a Federal Reserve interest rate increase of 50 basis points in an attempt to alleviate inflation fears. But are those fears justified? Most of the CPI increase was concentrated in lodging (up 3.8% for the month and 46% annualized) and clothing (up 0.9% for the month and 11% annualized). Those sectors typically show big jumps in March, and both are coming off periods of price discounting because of weak demand. And despite March's strong growth in jobs, 360,000 new claims for unemployment were filed in the week of April 5-9, according to the Labor Department. That's about 30,000 more than Wall Street and economists had expected. In addition, on April 16 the Fed reported that industrial production in March fell a surprising 0.2%, ending months of gains. Not surprisingly, the stock market has stalled as the prevailing counterforces of growth and inflation slug it out. Technical analysts call this a trading range; I call it stuck in a rut. This week, I'm recommending specific stocks to consider for a growth/inflation barbell portfolio strategy that balances out the opposing trends. There's no better place to begin looking for inflation-beaters than last Tuesday's market action.
Looking for Defensive StocksLast Tuesday (April 13), the Dow Jones Industrial Average dropped 134 points and the Nasdaq Composite fell 35. Investors were running for cover on fears that inflation and interest rate increases were just around the corner. Still, 113 stocks managed to hit new highs for the day. The list is dominated by defensive stocks in the energy, natural resources and food sectors. I'll draw from these to make up the inflation-fears end of my barbell.
Fortunately -- and not by chance -- Jubak's Picks is already heavily weighted in this direction. Ten of the current picks fall in this category. Energy stocks include BP ( BP), Shell Transport and Trading ( SC), Schlumberger ( SLB) and Teekay Shipping ( TK). Natural resource stocks include Freeport-McMoRan Copper and Gold ( FCX), Noranda ( NRD), Newmont Mining ( NEM), The St. Joe Company ( JOE) and Tejon Ranch ( TRC). Food stocks are represented by PepsiCo ( PEP). But what if you're still adding to this group or even just thinking about your first inflation-stock buy? The danger inherent in a group that has rallied as strongly as this one is that you'll wind up buying these stocks at a peak. And that would be just before the uncertain stock market decides to swing back in the other direction. PepsiCo is closing in on my May 2004 target price of $57. I'd call this one a hold now and wait until the market swings away from this group before buying more. The same goes for Schlumberger at $62 and Noranda at $17. But fortunately, thanks to speculators who built leveraged positions in gold and industrial metals stocks in anticipation of this moment and are now unwinding those positions, stocks in those two inflation-sensitive sectors have corrected to the point where some are now reasonable. If you're looking to add to your inflation-fears group, I suggest metals stocks Southern Peru Copper ( PCU) and Inco ( N) and, because drillers have lagged energy producers, oil driller National-Oilwell ( NOI).
Smart Growth StocksNow on to the other half of the barbell, the growth end. Here the market's recent action won't give us much help. Growth stocks have been out of favor ever since investors started focusing on inflation and interest rates. That out-of-favor status makes this a good time to buy shares in this group, but it also makes it harder to find them.
What am I looking for? A very rare two-part combination:
- Stocks that will deliver solid earnings growth as long as the economy is growing at even a modest rate, and no matter what inflation and interest rates do.
- Stocks that also trade at relatively modest valuations compared to that growth rate.
Low Volatility Has Value for InvestorsThat brings me to beta, another measure of a stock's risk and one that's central to the inflation fears/growth hopes barbell strategy. Beta is a measure of the volatility of a specific stock compared with the stock market as a whole. Thus, the market as a whole has a beta of 1. Stocks that are less volatile than the market get a beta of less than 1; stocks with a beta of more than 1 are more volatile than the market.
A low beta doesn't equal low gains in a stock's price: PepsiCo has a beta of just 0.4, but the stock has returned 39% in the last 12 months. A low beta does, however, equal a history of steady growth without big downside surprises. To make my strategy work, the two groups at the end of the barbell should have different betas. For the inflation fears group, I'm looking for betas below 1. I think that maximizes the strength of this group: steady, if sometimes slow, gains and very limited downside volatility. For the growth group, I'm looking for higher betas, maybe as high as 1.5. Those higher betas effectively leverage the potential good earnings news from these stocks, making them likely to move up more on good news. Yet by keeping beta below 1.5, I'm not taking on huge risk. From a beta perspective, then, PetsMart and SCP Pool are exactly what I'm looking for. SCP Pool has a beta of 1, and PetsMart a beta of 1.4. Now, you might ask, where do I get the cash to implement this strategy? From selling those stocks that don't fit this strategy. For example, even though Freeport-McMoRan is in the right industry, its high beta of 1.3 makes it a bad fit with the low risk I need from the inflation group for this strategy. I'm going to replace it in the inflation group with Southern Peru Copper and its beta of 0.6. And I'm going to fund my purchase of Wolverine by selling my shares of 2.4-beta Western Digital ( WDC).
Changes to Jubak's PicksSell Freeport-McMoRan Copper & Gold. The stock market overall is getting more volatile as investors worry about interest rate increases from the Federal Reserve. Plus, the gold and basic metals sector is getting riskier as traders unwind hedges and sell to reduce their leverage. Freeport-McMoRan carries more individual stock risk than I'd like. So I'm selling these shares and switching the money into Southern Peru Copper. I'm selling the shares with a 6% profit since I added them to Jubak's Picks on Sept. 23, 2003. (Full disclosure: I will sell my shares of Freeport-McMoRan Copper & Gold on April 23.)
Buy Southern Peru Copper. Shares of Southern Peru Copper have been hammered this year as traders who had borrowed cheap money to create leveraged positions in copper and copper stocks moved to take profits and cover their loans. The stock, which traded as high as $49.50 on Jan. 20, hit a 2004 low of $36.30 on March 24. Since then, it has behaved like a stock that has found its bottom. I like the shares of basic metals producers as inflation hedges and because of increasing demand from China, especially for copper and nickel. I'm adding Southern Peru Copper to Jubak's Picks with a September 2004 target price of $45 a share. Sell Western Digital. We could get a short-term bounce after the selling in the sector, but I expect technology stocks to show weakness until June. Part of that is seasonal: This is usually a rough period for technology stocks as companies come off their third-quarter and fourth-quarter sales and earnings peaks. Part of it is interest rate fears. With their high multiples, technology stocks are, along with financials and utilities, likely to bear more than their share of punishment as investors head for safety. I still like the underlying long-term trends in the disk drive business, as the devices get smaller and smaller and show up in more and more products. I'm not willing, however, to sit through this period of weakness in such volatile shares. I'm selling Western Digital with an 11% loss since I added it to Jubak's Picks on Nov. 21, 2003. (Full disclosure: I will sell my shares of Western Digital on April 23.) Buy Wolverine World Wide. This company continues to build on the success of its Merrell shoe line in the casual shoe market by acquiring new brands, most recently Sebago, and reviving its classic Hush Puppy and CAT brands. Net sales rose 8% in the fourth quarter, and Wolverine increased gross margins by 1.7 percentage points. The company generated $100 million in operating cash flow in the most recent fiscal year and saw its order backlog grow by 20%. The stock trades at 19.4 times trailing 12-month earnings per share. I'm adding the stock to Jubak's Picks with a target price of $28.60 by October 2004.