Looking for That Snap-Back

 | Feb 23, 2012 | 2:30 PM EST  | Comments
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There has been a lot of talk about mean reversion around Chez Melvin this week. The topic came up first in a discussion about whether economic activity does indeed have such tendencies, and my pet theory is this: It does indeed, unless heavy doses of monetary and fiscal policy are applied in an attempt to push the economy in the desired direction. Left to its own devices, I believe the forces of creative destruction and market-clearing prices would cause economic activity to show a strong mean reversion over time.

Of course, we will never know for sure, as global monetary policy dominates. But it's a neat theory to talk about over a nice bottle of wine. (Also during the conversation, my friend -- a Mets fan -- and I decided that baseball teams unfortunately do not mean-revert, and that we were both probably looking at another long season.)

In any case, my friend and I both agreed on one thing: The majority of individual stocks do revert to the mean over time. Absent severe financial difficulties that raise the likelihood of bankruptcy, stocks that have done poorly usually catch back up to the average market return over a reasonable period. On the flip side, those that outperform tend to come back to earth once their momentum breaks, usually as the result of an earnings miss or a lowered forecast.

The market has staged a rally of 20% or so since the October lows. Most of the stocks in the S&P 500 have come along for the ride, with 460 of 500 names having moved higher since six months ago. With that in mind, I sat down and ran a screen to see which S&P 500 stocks had failed to participate in the recent rally -- and which, as a result, might be setting up for a reversion-trade opportunity. I usually avoid stocks in the tradable indices and ETFs if possible, but in this case the bullish bias of black boxes and ETF traders should actually be a plus in pushing our stocks back toward the average return of the market.

One stock that stuck out at the very first glance is Alpha Natural Resources (ANR). Coal companies are very much feeling the effect of low natural gas prices, with the latter gaining preference among utilities and other firms, and that is creating an oversupply of coal in the short run. However, coal companies will begin to reduce production in 2012, and that should allow for some firmer pricing.

Also, Alpha Natural has just about finished integrating its Massey Energy takeout, completed back in June of last year, and this will lead to the company's best year ever in terms of production and revenue. Strong demand from Asia should furtherore help the firm offset some of the weakness in domestic coal demand. The stock trades at just one-third of the 52-week high and, would seem to be a strong candidate for mean-reverting price activity in 2012.

Other companies feeling the pinch of lower natural gas prices have included nat gas companies, themselves. Shares of Chesapeake Energy (CHK), for instance, have lagged the market for the past six months as low commodity prices have pressured the top and bottom lines. The company is going to need to sell more than $14 billion in assets in order to meet its cash needs over the next year. Chesapeake has shut down two-thirds of its natural gas drilling activities amid the falling prices, and the company plans to increase its liquids production this year. The stock has moved off the bottom, but is still a strong mean-reversion possibility, especially if gas prices rise at all this year.

Away from energy, one of the worst-performing S&P 500 stocks in the past six months has been Sprint (S). Since falling into single digits in 2008, this name has become the turnaround that will not turn. In addition to all of the company's other problems, there is a good chance that its 4G network provider, 54%-owned Clearwire (CLWR), is going to need more money in the near future.

Sprint does appear to be gaining some traction, as its iPhone deal with Apple (AAPL) helps with new subscriber additions. Also, prepaid business is doing very well amid its Virgin Mobile and Boost offering, but Sprint lost money last year and will probably lose even more in 2012. Buying this stock right now would be a bet on Sprint's success on two fronts: iPhone subscriber additions and the 4G Network Vision expansion. In addition to being a candidate for a mean-reversion trade in 2012, at Sprint's current price the stock is a call option of CEO Daniel Hesse's ability to execute the turnaround and growth plans he has set forward.

I am not going to run out and put on any of these trades right away. I own a little Sprint and am comfortable with what I've already got. I look at mean-reversion candidates not just for trade ideas, but also for an idea of what is going on in the market -- and, based on what I see from my list, the big story right now has nothing to do with Sprint. Instead, it's all about the continuing weakness and possible opportunities in gas- and coal-related stocks.

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