Playing the Rebound

So the market has finally remembered it can go up, and it appears that it's also learning how to sustain its rally. The foundation of this economic recovery is that the oversupply of goods and services that has been hobbling the U.S. economy — “too much fiber optic bandwidth, too much vacant office space, too many empty airplane seats,” is how The Wall Street Journal described it — is starting to abate as demand heats up. Since companies do not need to increase capacity to fill that demand, corporate profits are expected to rise, which of course is good news for the markets.

The rebound also looks solid from a technical perspective. “Typical recoveries are led by growth stocks, which rose by a nearly a third during the second quarter,” says Kevin Marder, chief investment strategist at the New York brokerage Ladenburg Thalmann. “And the summer's consolidation further supports the case for the rally's continuation: Trading volumes dried up during pullbacks, keeping shares from significantly falling,” and that shows that institutional money remains committed to stocks.

In short, Marder believes we are headed toward a sustained bull market.

So assuming these predictions are correct, what criteria should weigh most heavily in the choice of equities in the coming months? An important starting point for any such discussion is to note that today's recession-recovery differs in important ways from the one in the early 1990s. There are similarities, of course — the presence of U.S. forces in Iraq, for instance — but the differences are even more striking. To wit, the current economy requires a whole new strategy — one that takes into account, among other things, the commoditization of technology (which rewards manufacturing efficiency over innovation), the deregulation of the airline industry (which has helped bankrupt inefficient incumbents and produce no-name industry leaders) and, strangely enough, the price of goods and services sold (which some stock valuations of the late 1990s rendered temporarily irrelevant.)

Here are some other important trends to consider in weighing equities purchases in the coming months, along with some suggestions of companies that stand to gain from the trends.

Staffing

A rise in temporary staffing is frequently a harbinger of economic recovery. Temp employment bottomed out at the end of 2001 in the three largest temp markets, the U.S., U.K. and France. But Credit Suisse analyst Matthew Smith “sees potential for a recovery in U.S. staffing volumes in the second half of 2003, with a 1 percent increase in employment, possibly leading to a 19 percent increase in [temp] staffing volumes.”

Smith says a 10 percent increase in revenue at Adecco, the world's largest temp agency, can translate into a 65 percent rise in EPS. And despite run-ups in brand leaders since the spring, Smith still sees believes “significant upside potential, especially for Adecco and Vedior.”

Low-Cost Airlines

The exponential growth of low-cost airlines is transforming the industry, and, in the process, creating a group of new investment choices that are likely to surf the leading edge of the market's recovery.

Southwest Air retains its status as the country's most consistently profitable airline. According to James Parker, analyst at Raymond James, Southwest is poised to exploit markets being vacated as larger airlines struggle to cut costs. This could drive EPS growth by 50 percent annually over the next several years.

Parker also sees remarkable profit possibilities in two newer low-cost competitors, Jet Blue and AirTran. Parker expects Jet Blue's earnings to double and AirTran's to quintuple between 2002 and 2004.

Technology

It's not easy convincing investors to return to the scene of the crime, but selective reentry into tech, while still somewhat risky, promises some great rewards. In this context, many consider Dell a solid pick, especially as computer hardware becomes more commoditized. While trading well short of its all-time high in 2000, the company's shares have been moving upward since the start of 2001. Many industry observers, including Bear Stearns industry analyst Andrew Neff, believe Dell's “as needed” production model will help it avoid earnings drags that less nimble competitors might face.

Another popular choice is the dot-com-curse-defying eBay, which remains one of the most innovative growth stocks around. With a return on equity of 25 percent, a 50 percent growth rate and a market cap of $37 billion, the stock is trading near its all-time high and many analysts, including Jeetil Patel of Deutsche Bank, say there is room to move upward.

Banks

Banks already have enjoyed a strong spring and summer rally, and many expect it to continue. One reason for the optimism, according to Bear Stearns banking analyst Ian Jaffe, is the continued improvement of asset quality, as the fundamentals of corporate borrowers continue to stabilize. Further, he views rising interest rates as a net positive for the industry, since institutions can reinvest low-cost core deposits into higher-yielding instruments. Fox-Pitt Kelton's U.S. bank research group adds that bank stocks' above-average dividend yields add to their appeal, especially in light of the new dividend-friendly tax laws.

A favorite pick among a number of analysts is Bank of America. UBS' John McDonald forecasts a cumulative EPS expansion of 18 percent between 2002 and 2004. The stock pays out an annual dividend of more than a 4 percent.

Meanwhile, Sanford Bernstein banking analyst Evengelos Kavouriadis highlights western European banks, favoring those in the U.K., whose first-half profit margins of 39 percent were the best in Europe. Barclays and Abbey National head the class, with earnings projected to grow 43 percent and 20 percent, respectively, through 2004.

In the end, though, the current equities market remains in a fragile state. On the surface, things are good, but Morgan Stanley economist Richard Berner warns that a deteriorating of job market, rising bond yields, high energy prices and a weak global economy could still conspire to undermine the recovery.

Brokers should therefore set modest profit goals. Once exceeded, they should upwardly adjust sell orders to ensure gains. And, of course, it's important to make sure to monitor the stop-loss mechanisms, because, ultimately, no one knows how safe this market really is.

INDUSTRY LEADERS