Stock Market Outlook: Any Claus for Concern?

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What’s in Store for the Rest of the Year?

The S&P 500 is up almost 2% over the past two weeks. We expect this “Santa Claus Rally” to continue as a general uptrend for the rest of the year and likely into January for the stock market. Absent any political or global instability, we think investors will be able to sit back, relax, and enjoy a nice cherry on top of their gains for the year.

This does not mean investors should stop doing their diligence. While most stocks are moving upward, prudent investors should look closely at the following sectors and determine if they are taking advantage of the right trends and shielded from any turbulence.

Why You Need to Tread Carefully in the Energy Sector

You have probably noticed the Energy sector in the news this month. With WTI crude oil falling as low as $66/barrel, consumers are benefitting, but the outlook for drillers, refiners, and distributors has been pretty grim. Since November 14, the Energy Sector SPDR (XLE) is the only sector to have dropped in value. It has lagged the second-worst performing sector, Materials (XLB), by over 5%.

Weaker, overvalued companies like driller Seadrill (SDRL) have been hit the hardest. In early September SDRL was trading as high as $37/share. This gave SDRL a price to economic book value (PEBV) of over 3.7. Stocks that trade this high above their economic book values are inherently very risky, and as a result Seadrill earned our Dangerous rating.

Factor in Seadrill’s huge total debt of over $15 billion and its weak free cash flow and this was a disaster waiting to happen. Seadrill was forced to cut its dividend last week, which was probably a prudent move given the company’s weak cash position. SDRL now trades at ~$14/share, down 64% from its levels in early September. Seadrill is a textbook case of what happens when weak cash flows and a poor risk-reward rating can come back to bite investors. All it takes is one catalyst for the market to wake up to the true economics of a business.

It’s Hard to Lose in Health Care

The Health Care sector has been the strongest performer as of late, with the Health Care SPDR (XLV) up nearly 4% since mid-November. XLV earns our Attractive rating due to the quality of stocks in the Health Care sector.

While biotech companies make up a large portion of this sector and tend to be riskier, there are plenty of good Health Care stocks to choose from. Among them is Stryker (SYK). When we wrote on Stryker in June, we noted that its cash flows were greater than what appeared on the surface. Stryker was also attractively valued then with a PEBV of 1.2. This ratio implies that the stock market expected Stryker’s profits to rise by only 20% for the remaining life of the company.

Since that report, SYK has risen over 13%, outpacing the S&P 500 by nearly 10%. Luckily for investors, SYK still has a PEBV under 1.3. This number implies that the stock market expects Stryker to grow operating profits (NOPAT) by less than 30% for the remaining life of the corporation. Considering the fact that Stryker has grown profits by 18% compounded annually for the past 13 years, the expectations embedded in Stryker’s stock price seem rather low and Stryker remains an attractive investment.

Andre Rouillard contributed to this report.

Disclosure: David Trainer owns SYK. David Trainer and Andre Rouillard receive no compensation to write about any specific stock, style, or theme.

Photo credit: Fabrizio Lonzini (Flickr)

About The Author

Andre Rouillard

Investment Analyst at New Constructs

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