Since mid-October, the stock market’s movements have resembled mob action. Mobs move violently and sometimes irrationally. Taking control of a mob without strong leadership is impossible, and such leadership has been in short supply on Wall Street.
As the table below shows, all but three sector indexes within the S&P 1500 Index have declined over the last two months. Two of the three best-performing sectors — utilities and telecom services — are among the smallest, combining to make up about 7.9% of the index’s market value. Neither sector has enough heft to lead a sustained movement in the broader market. Energy represents 13.1% of the market but tends to move in line with energy prices.
So what stocks are leading the market? And where are they taking us?
Interestingly, despite a spate of weak economic data, economically sensitive stocks have set the pace since the market reached its 2008 low on Nov. 20. The S&P 1500 Index has bounced 22% from that low, with every sector up. The biggest gainers have been the financials, consumer-discretionary, telecom, and industrial sectors. While the telecom sector is tiny, the other three each represent at least 11% of the index and seem capable of shaping the market’s course.
Financials are a wild card. They’ve managed the biggest rally (sector index up 37% since Nov. 20), but are also rebounding from the lowest point. The S&P 1500 Financials Index fell 66% from the end of 2007 through Nov. 20, by far the worst of any sector. Given that the average financial stock in the S&P 1500 earns a Quadrix® Overall score of 38, suggesting the sector’s fundamentals remain weak, it is difficult to see financials leading a lasting upward move.
The consumer-discretionary and industrial sectors provide more reason for optimism. While both are cyclical and thus vulnerable to continued weakness in the economy, both also boast decent Quadrix scores. The average industrial stock in the S&P 1500 earns an Overall score of 68. The average consumer-discretionary stock scores 56, roughly in line with the average for the broader index. When sectors with solid fundamentals and attractive valuations move aggressively higher, the resulting rally could have legs.
The S&P 1500 Energy Sector Index is up 24% since Nov. 20, similar to the broader index even though oil prices remain near lows not seen since January 2005. Expectations for the sector are modest, with the average energy company in the S&P 1500 projected to post a 9% decline in per-share profits in the next fiscal year. That leaves a lot of room for outperformance if energy prices rebound. On average, energy stocks trade at a 59% discount to their five-year average valuation — no other sector is that cheap — and earn an attractive Overall score of 87. We like that blend of value and fundamental strength.
As oil prices plunge, so widens the chasm between Chevron’s ($79; NYSE: CVX) expected 2008 earnings and those anticipated next year. The consensus projects that 2009 per-share earnings will fall 37% from 2008’s record high, though the 2009 estimates range from $4.80 to $10.28. The shares, down 24% from May highs despite a strong upward move over the last six weeks, trade at 16 times the lowest 2009 estimate and less than eight times the high estimate. As suggested by the wide range of profit estimates, Chevron’s perceived value depends largely on expectations for oil prices.
While low oil prices could weigh on Chevron shares in the near term, the stock has maintained its value better than most. It is down 15% so far this year, versus a 35% decline for the S&P 1500 Energy Sector Index. Chevron’s diversification — operating both upstream and downstream businesses — lessens its exposure to energy-price movements. Lower oil prices hurt production earnings but tend to boost refining margins.
In the coming year, Chevron is likely to spend heavily on capital projects, raise its dividend for the 22nd straight year, and continue buying back stock. Outstanding shares have declined by more than 9% over the last 12 quarters. Chevron is a Buy and a Long-Term Buy.
General Dynamics ($56; NYSE: GD) has been an adroit shopper in the acquisition market. The company has made seven major purchases since June 1999, with most received fairly well on Wall Street. But many see General Dynamics’ latest deal, the $2.2 billion purchase of Jet Aviation, as a misstep, at least in the short term. The global economic downturn has grounded the business-jet market. But a balanced business mix and robust backlog should support profit growth until the airplane market recovers.
Strong finances should allow General Dynamics to take advantage of acquisition opportunities. Operating cash flow rose 25% and free cash flow increased 30% in the nine months ended September, and General Dynamics holds more cash than long-term debt. General Dynamics also boasts a funded backlog of $49.7 billion, almost twice annual sales. The consensus projects per-share earnings will climb 21% in 2008, marking the fifth straight year of double-digit growth, followed by a 10% gain in 2009.
At 10 times trailing earnings, General Dynamics looks cheap relative to the average P/E ratio of 17 over the last three years. A return to the historical average by the end of 2009 would vault the stock price above $115. While such a gain is not likely, the stock seems capable of rising at least 25% over the next year. General Dynamics is a Buy and a Long-Term Buy.
Oceaneering International’s ($27; NYSE: OII) stock is cheap relative to its history. The shares trade at seven times expected 2009 earnings, versus a five-year average forward P/E ratio of more than 14. Some expansion of the P/E multiple should drive market-beating returns. Earlier this month, the company said it expects profits to reach at least $4.00 per share in 2009, up 12%, assuming oil averages $70 a barrel. Today’s consensus for 2009 earnings is $3.77 per share, partly because oil prices are below $50.
The global supply of floating drilling rigs has held steady despite a 33% rise in demand since 2004, and Oceaneering estimates that the market is at 97% capacity. The company anticipates demand for rigs will continue rising at a similar pace through 2012 and has ramped up production of rig equipment and supplies to meet that need.
Cash flow fell in the September quarter but rose 23% in the nine months ended September. So far this year, Oceaneering has increased its long-term debt by more than 50%, spending half of that cash to repurchase stock, with the rest most likely allocated to capital projects. While Oceaneering’s borrowing reduces its flexibility to deal with a prolonged stall in oil prices, the stock’s valuation adequately reflects those risks. Oceaneering is a Focus List Buy.