Can the Stock Rally Last? Here's why it's not too late to catch the momentum market
(MONEY Magazine) – Bull markets, so they say, climb a wall of worry. This one has vaulted right over anxiety and leaped to euphoria.
Since March 31, the S&P 500-stock index has risen 34%, and the run has been straight up. Stocks have gone 300 days--and counting--without a 5% correction from the high point of this rally. That makes this the 11th-longest uninterrupted upturn since 1928, and one of the strongest. What's more, nearly every sector of the market, from new-economy Internet stocks to old-world metals, is rising. Ned Davis Research says stock momentum is greater than it was even in late 1999: Last year the average daily ratio of advancing stocks to declining ones traded on the New York Stock Exchange was 116 to 1. That's the highest yearly reading on that classic gauge of bullishness since 1958. Welcome to the momentum market.
Of course, the rapid rise has some investors griping that there are few values left. "It's extraordinary that we could get back to this level of speculation so soon after the last bubble burst," says Chuck Royce, noted value investor and portfolio manager of the Royce Funds. Royce expects a correction before the quarter is out.
Corrections are inevitable--but we don't think a crash is coming soon. In assessing this market, MONEY looked at how momentum works. What we found suggests a bullish 2004. We've also identified a promising way to pick stocks in this market and three stocks we think are likely to keep rising.
WHAT MAKES "MO" GO?
Even famed value investor Benjamin Graham, in the 1974 edition of The Intelligent Investor, observed that some shares rise for no reason other than "strong market action over past years"--that is, momentum. But to the logical Graham, who picked stocks by studying balance sheets, this seemed crazy. He advised avoiding the "good-will giants."
But let's look a little closer. Narasimhan Jegadeesh, a professor of finance at Emory University, has found that from 1965 to 1998, an investor who bought the best-performing stocks from the past six months and held them for the next half-year would have outperformed the market by an average of six percentage points a year for that period. Why? We underreact to news, says Jegadeesh. But once our views have been validated, usually by a rising stock price, we rush in. That means stocks may move long after good news.
People also assign more importance to news that reflects the way they feel, and less to news that doesn't. "In an up market, you find that bad news turns out to be not so bad," says George Loewenstein, a professor of economics and psychology at Carnegie Mellon.
Research from Ned Davis comes to the same conclusion. The firm looked at stocks since 1926 and found that when the ratio of advancers to decliners is high in one year, returns in the next year are strong. On average, stocks rose 13% in the year following a ratio above 108, compared with a rise of just 2% in years after a reading below 94. Remember, we're at 116 now--a sign of more boom ahead.
HOW TO RIDE THE RALLY
You should never buy a stock based on momentum alone, and we don't advise the kind of trading-intensive strategy Jegadeesh is talking about. Even pros who use momentum strategies admit that they're playing with fire: If you bought the top stocks of late 1999 in early 2000, you would have been stuck with tech shares that underperformed the market for the next 2 1/2 years. But considering momentum along with such traditional value tools as price multiples may boost your returns.
To zero in on good stocks with the wind at their back, we examined the 25 top performers in the S&P 500 over the past six months. We then looked for bargains among them. In his book What Works on Wall Street, money manager James O'Shaughnessy studied market data from 1954 to 1996; he found that the best-performing portfolios held momentum stocks with low price-to-sales ratios. So price/sales--the market is at 1.7--was our key valuation number. (See the charts below.) Here are our picks.
GEORGIA-PACIFIC (GP) Sales at this paper company are rising, thanks to an improving economy and a falling dollar, as well as a building-products division that's benefiting from the strong housing market. What's more, three years ago Georgia-Pacific bought Fort James, which makes toilet paper and paper towels. Selling consumer staples has added stability to the company's earnings and cash flow.
AVAYA (AV) We featured Avaya in "Best Investments for 2004" (January) because of its technology for sending telephone calls over the Internet (VOIP) and other data lines. We still like it, even though it's risen to $17 from $13 two months ago. Because Avaya already sells phone systems to corporations, it is poised to benefit from rising demand for VOIP technology. At a price/sales ratio of 1.7, Avaya's shares still look reasonable to us.
NORDSTROM (JWN) By adding lower-priced, hipper items, the department store chain won back ground it had lost to discounters in the late 1990s. Still, it has maintained its upscale image and is benefiting from an economic upturn. Analysts estimate that its earnings, excluding one-time charges, rose 39% in its latest fiscal year.