Loving the Rally?

 | Mar 11, 2013 | 9:30 AM EDT  | Comments
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Stock quotes in this article:

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So you love this rally and want equity exposure. Unless you are simply going long the SPDR S&P 500 (SPY), you still have your work cut out for you. You still need to pick your best sector exposures, and then, unless you are using sector ETFs, you still need to pick stocks. Much of our readership only needs absolute returns, but the institutional portfolio managers may also need to beat the S&P 500 or some other benchmark, which will require significant additional analysis.

Here on Real Money, we always stand at the ready to assist -- especially since we are working through the same issues ourselves as we position our clients' portfolios. I remain cautious -- not bearish -- on this rally. Because my mandate is to be mostly fully invested long, I am picking apart the sectors looking for strong relative performance candidates in order to beat the market.

My starting point for choosing stocks is always to look for a combination of strong earnings momentum and reasonable valuation. I can quickly eliminate 95% of stocks because their earnings estimates are not being revised upward strongly. I can also eliminate the large coterie of names whose valuations are not cheap relative to their prospects. The remaining names have great potential to outperform.

I ran the S&P 500 through my screening process to see what looks good -- and bad --right now. The table below shows key names from the S&P 500 in each sector, as defined by Factset's more fine-grained industry definitions. The best sectors are those with an "earnings revision rank" that is 5 or higher. This "rank" is a number from 1 to 10 defining the strength of the estimate revisions, with 5 being average, 1 being great, 10 being horrible. No sector happens to be above average now, but several simply stink. Please just underweight nonenergy minerals mining, industrial services mainly oilfield services, transportation and communication. I own little in those sectors.

S&P 500's Earnings Momentum
Source: Factset

I broke open the sectors so you can see the S&P 500 names in each. To make the table readable, I eliminated most names, presenting only those with a strong earnings rank 1 or 2 and the really bad ones 9 or 10. If you own the bad ones, sell now. The odds of them helping your portfolio are low in the near term. If you want to hold them, you need a really good reason, such as the possibility of a potential takeover.

Among the highly ranked earnings names, I favor the lower valuations. I highlighted names I own right now, and not surprisingly many others are on my radar screen for further research. I just bought Deere (DE) last week, and am digging into Boeing (BA), which has great estimate revisions and is reasonably valued, due to the Dreamliner fiasco. Housing is working now and D.R. Horton (DHI) looks great on earnings, although the shares are somewhat expensive. I would use Whirlpool (WHR) instead, which has the same exposure and is cheaper.

The energy minerals sector is oil and it rules. The best earnings names are dirt cheap. I am coining money in Marathon Petroleum (MPC) -– my best performing name this year – but all the top names look great. Only Range Resources (RRC) seems too expensive. A number of Health Technology names look great, I am already in Mylan (MYL) and Eli Lilly (LLY), but they all have great momentum and good valuations.

In consumer non-durables, I have Tyson (TSN) and there are plenty of food names, all of which benefit from an inflationary environment and could be the next Heinz take-over candidate. Clothiers are less prevalent, but Ralph Lauren (RL) looks OK, just a tad expensive. I own the only good name in Industrial Services, Helmerich & Payne (HP), the "other HP." The rest are dogs and should be avoided.

In technology services, which is basically software, the pickings are surprisingly slim. I own Symantec (SYMC), which seems to have an evergreen market, since security never seems to fade as an issue. In consumer services, I cannot stomach the valuation in Netflix (NFLX), although the earnings are good and I am a recent subscriber, so I like the service. H&R Block (HRB) is timely this tax season, and I am there. International Game Technology (IGT) tickles my fancy, and could be worth some extra effort.

In retail, I am there on Gap's (GPS) turnaround. Interestingly, the "inferior goods" all look weak, perhaps due to the recent tax increase mainly falling on the shoulders of the middle class and poor. Don't listen to the political rhetoric: The payroll tax was raised 50% on working people. That Wal-Mart (WMT) seeing horrific sales should be no surprise.

There is nothing in transports, and I only use utilities as filler. I own Edison (EIX), but there is no real growth in that sector, just dividend income. Financials have a lot of names simply because it is a huge sector, 16% of the S&P 500, and there are several good looking names. I am in JPMorgan (JPM), Goldman Sachs (GS), and Blackrock (BLK) already. Any of the top names would be good -- only Cincinnati Financial (CINF) looks too expensive.

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