3 stocks to buy despite uncertain market

Portfolio manager John Stephenson says that while there is plenty to keep investors up at night these days, equity markets still remain the best relative alternative in a world of expensive alternatives. Markets will continue chugging higher in the coming year, he says, and picks a tech stock, a mining stock and an oil and gas stock that will perform well.

Market_OutlookMarkets have been hitting new highs, with the Dow hitting 26000 and sprinting 1000 points to this new milestone just eight trading days from hitting its previous high, its fastest run ever. Most of the recent gains have been powered by certain money managers and individual investors, who have long been wary of the nearly nine-year bull market.

The NASDAQ Composite Index recently closed at an inflation-adjusted record for the first time in nearly two decades, surpassing its peak of March 2000, at the height of the tech boom.

Some market observers have dubbed this phenomenon Fear of Missing Out, as stock market records are falling almost on a weekly basis. Others refer to it as a “Melt-Up” market, where the prevailing mood is shifting to greed from fear, and investors stampede in without worrying much about valuation or fundamentals.

Are we in for a “melt-up”?

When price gains get downright ridiculous, it’s referred to on Wall Street as a ‘melt-up’, perhaps because these self-perpetuating rallies tend to be followed by meltdowns. This is the uncomfortable prospect that many investors are contemplating. For those of us old enough to remember the dot-com boom and bust, it’s tempting to assume the market will never become that irrationally exuberant again.

Investors’ optimism about global stock markets is spurring a rotation out of bonds and into equities and cyclical sectors. Recently, Bank of America Merrill Lynch noted that allocation to equities has climbed to a two-year high, while money devoted to bonds has fallen to a four-year low.

According to Bank of America, the majority of investors now do not expect equity markets to peak until 2019 or later, a notable recent extension of their timescale forecasts; last month the majority of those surveyed said they anticipated the top to come in the second quarter of this year.  Investors are buying into technology, industrials and emerging markets, and shifting out of defensive stocks such as telecoms and utilities.

Investors who have been piling into the market recently seem to have history on their side. On average, roughly 40 per cent of a bull market’s gains occur in the first 12 months and an additional 32 per cent in the final 12 months, according to research conducted by Longview Economics.

And stocks appear to be gaining steam. One-third of the S&P 500 recently ended at their best prices in at least a year, the strongest ‘breadth’ measurement since 2013. At the same time, at least nine out of 10 stocks on the S&P 500 sectors coasted above their 50-day moving averages, another rare show of strength.

Even small investors are showing renewed faith. About 60 per cent of individual investors said this month that they think the stock market will go higher over the next six months, the highest percentage since 2010, according to a recent American Association of Individual Investors survey.

Stock market outlook: pick your stimulus

The main engine propelling stocks higher has been record low interest rates, many investors believe, and an exorbitant amount of stimulus from the world’s major central banks. These forces encouraged risk, pushing big institutional investors into stocks when bond yields were too low to get needed returns.

Now the new bulls say that stocks are rising for more fundamentally sound reasons. US economic growth was better than 3 per cent in the third quarter, the fastest pace in more than two years. The World Bank this month said the global economy would grow 3.1 per cent in 2018, on track to be the first year since the financial crisis that it will be operating at near or full capacity.

The new US tax law that cuts corporate rates to 21 per cent from 35 per cent is likely to give earnings another boost. Goldman Sachs analysts estimate the new law will boost per-share earnings growth in the S&P 500 by 5 per cent in 2018.

Yet for other investors, the recent bandwagon hopping looks worrisome. One of the biggest allures of the stock market over the past decade has been the deep skepticism of many investors in the run-up. Naysayers finally capitulating can look like the market’s last gasp.

Some say the quick rise is a little too reminiscent of the tech-heavy NASDAQ Composite’s run in late 1999 and early 2000. During that period, the NASDAQ took 38 trading sessions to advance from 3000 to 4000. Just 49 sessions later it topped 5000, shortly before the dot.com bust.

What I recommend

Yes, markets are arguably expensive in historical terms. But this environment of accelerating earnings and economic strength is what is catching markets’ attention right now.

In 2017, the S&P 500 was up 19.4 per cent and 21.8 per cent when the impact of dividends are factored in. A global, synchronized recovery drove stock returns with forward looking economic indicators, such as purchasing managers’ indices, contributing to earnings upsides across markets. The tech sector managed to contribute just over 40 per cent of the total market return in 2017. Despite the fact that 2017 was a very strong year, the historical reality is that the subsequent year is also typically a very strong year.

Portfolio strategists are forecasting a year-end S&P 500 target of 3000, which implies just under a 12 per cent return from here. They base this estimate on a pickup in GDP forecasts for the upcoming year, and the recent US tax changes. When everything is factored in, Credit Suisse estimates that earnings per share (EPS) for the benchmark index will be up 17 per cent in 2018, with half of those gains coming from tax reform. Leading the pack in terms of sectors for the year will be technology once again, as well as energy and materials.

A subscription-based technology stock

One tech stock that I continue to like is Netflix (NASDAQ—NFLX). It is an online entertainment, subscription business that has more than 100MM streaming subscribers globally. For an approximate price of $8-14/month (depending on a user’s plan), subscribers receive unlimited access to curated TV shows and movies.

I believe that Netflix has achieved a level of sustainable scale, growth, and profitability that isn’t currently reflected in its stock price. This conclusion is based on the assessment by independent analysts of Netflix’s 53 million US and 56 million international subscriber bases, which makes Netflix one of the largest global entertainment-subscription businesses. I have a ‘Buy’ rating and a twelve-month price target of $260 per share for Netflix.

An oil and gas stock making strategic acquisitions

In the energy space, one oil and gas stock I like is Canadian Natural Resources (TSX—CNQ). Canadian Natural Resources has become a dominant independent in Western Canada, with roots that stretch back to 1988, when Murray Edwards joined forces with Allan Markin to create a junior producer with a focus on medium- and low-risk development opportunities. Through successive stages of growth, which have involved both property and corporate acquisitions, CNQ has emerged as the largest heavy-oil producer in Western Canada.

Over the years, CNQ has made a series of larger strategic acquisitions. CNQ should undergo a substantial increase in its free cash flow in 2018, as its Horizon expansion and AOSP (Athabasca Oil Sands Project) acquisition bear fruit. CNQ’s free cash flow generation opens the door to balance-sheet deleveraging, shareholder returns, organic resource development and opportunistic acquisitions. I have a ‘Buy’ rating and a twelve-month price target of $52 per share for Canadian Natural Resources.

A metals and mining stock offers attractive returns

In the materials sector, metals and mining stock First Quantum Minerals Ltd. (TSX—FM) looks poised to breakout to the upside. First Quantum has grown from its roots in exploration, development, and mining of copper and gold in Africa to a global producer of copper and nickel, with six producing mines and six development projects in eight countries spread across five continents.

The company’s operations include the 80-per-cent-owned Kansanshi copper-gold mine and the 100-per-cent-owned Sentinel copper mine in Zambia, the 100-per-cent-owned Las Cruces copper mine in Spain, Guelb Moghrein copper-gold mine in Mauritania, Çayeli copper-zinc mine in Turkey, Pyhäsalmi copper-zinc mine in Finland, and the Ravensthorpe nickel mine in Australia. I believe that First Quantum offers investors the potential for attractive returns based on its copper production growth over the next 3 years, and management’s project development and mining expertise. Over the 2017-19 period, I estimate a 2-year copper production CAGR (compound annual growth rate) of 22.4 per cent. I have a ‘Buy’ rating and a twelve-month price target of $24 per share on First Quantum Minerals.

While there is plenty to keep investors up at night these days, equity markets still remain the best relative alternative in a world of expensive alternatives. Markets will continue chugging higher in the coming year—a good news story for investors.

John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse”. He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or jstephenson@stephenson-co.com.

This is an edited version of an article that was originally published for subscribers in the January 2018/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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