In a rocky stock market, play it safe

Do your stock shopping among the ugly ducklings, not the swans, says the head of a leading research house.

By John Eade, Fortune columnist

(Fortune Magazine) -- Up and down Wall Street, traders' screens are green, signaling that these are great times for stock market investors. The S&P 500 and the Dow Jones Industrial average are setting all-time highs. So much cash is sloshing around the sidelines, and borrowing costs are so low, that practically each day brings news of asset sales or corporate takeovers. Reuters. Chrysler. Stuyvesant Town. MGM.

It all seems like the late 1990s.

Which makes us worried at Argus Research. We've been in the independent research business since 1934 and have seen the cycles the markets endure. Trust us: It is never "different this time around."

In fact, there are more signs for caution than for full steam ahead.

For one thing, investors have become extremely complacent, reducing the volatility in the marketplace and assuming that the good times are here to stay. The CBOE volatility index, a widely followed measure of risk, is lower than it's been in more than ten years.

For another, while the markets are setting records, corporate profit growth is slowing and may be poised to slow further, in part because of rising labor and energy costs.

For a third, valuations are rising. The P/E ratio on forecast S&P 500 earnings is now 16, in the upper end of the 13-to-18 range that has prevailed since 2001. Higher market multiples correlate closely with lower inflation and interest rates.

Alas, our economic forecasts call for rising pricing pressures and a steady federal funds rate. In short, investors may be disappointed if the Fed doesn't cut rates anytime soon - and we don't think it will.

Given these trends and outlooks, we recently signaled to our investor clients that they should consider paring back the exposure to stocks in their portfolios. Specifically, we lowered our tactical asset allocation recommendation for stocks to 55 percent. During my 18 years at the firm, we have been as high as 70 percent and as low as 50 percent.

But we do see opportunities. And they tend to be in areas that many investors are ignoring.

Take the housing market. Every month investors get a new statistic about housing starts, new permits, or average prices. The noise is confusing.

The one indicator we like to track is inventory. Over time this indicator has fallen as low as three months and risen as high as nine months (during the last housing recession, in 1991). The reading today is 8.4 months, which suggests that the sector's decline is much closer to the end.

We have been upgrading select housing stocks - conservative firms that don't have as much land or debt on the books as some others in the group. Our top pick is MDC Holdings (down $0.09 to $52.05, Charts, Fortune 500), which owns only a two-year supply of building lots vs. eight for some its rivals.

We look at energy in a unique way too. Most folks are grumbling as they fill their SUVs this summer. But with gas prices topping $3 a gallon, we expect demand to continue for oil drilling equipment. Helmerich & Payne (up $0.28 to $33.33, Charts) sits in the sweet spot of the onshore drilling market, and we expect it to continue posting strong revenue and earnings increases.

Last, let's venture into the subprime-mortgage mess. In some cases, in our view, investors have overestimated the threat to some diversified financial institutions. So we recently upgraded our rating on one such bank, Wells Fargo (up $0.14 to $35.48, Charts, Fortune 500).

While other large commercial banks have struggled to adjust to weaker housing markets and a tough interest-rate environment, Wells Fargo has continued to produce double-digit growth in revenues and earnings. Its typical valuation premium over its peers has all but vanished as investors have punished any and all banks that have a significant mortgage business.

John Eade is president of Argus Research, an independent stock analysis firm. This is one of a series of columns written by leading stock and bond experts.  Top of page