The Growing Disconnect

 | Sep 28, 2012 | 3:30 PM EDT
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I am pleased to report that my record as the world's worst short-term market timer remains solidly intact.

Last week I said that even though serious long-term considerations pointed to the possibility of serious downside action, the short-term path of least resistance remains higher. The market has been down just about every day since. I will eschew any further short-term market predictions, but it appears that the longer-term considerations for the market are becoming direr by the day. In spite of the last few days, It's another up month and quarter for the stock market.

The S&P 500 is up more than 2.5% on the month and almost 10% for the third quarter. Year to date, prices have climbed almost 17%. My collection of safe and cheap stocks has done very well as the market rises, so I am not complaining by any stretch of the imagination. But there seems to be a huge disconnect between the market and the underlying economy. The latest collection of economic reports has been horrible. Durable goods orders, personal income, GDP and jobs reports all show signs of a weakening economy. This does not paint a pretty picture as we go into earning s season. Will investors continue to settle for revenues and earnings that are lower but ahead of expectations? Have analysts raised their expectations higher than reality? Either scenario could touch off selling in the stock market.

Now is a good time for investors to consider which stocks they should sell or avoid going into the final quarter. Each week I track changes in Value Line rankings to see which stock might be vulnerable and showing signs of weakening earnings and price momentum. Often, these will be the stocks that lead the market lower if there's a fourth-quarter selloff. The most recent changes are very instructive and seem to support the position that a weaker economy could lead the market lower.

One of the biggest negative rank changes was for Norfolk Southern (NSC). The railroad saw its shares drop from the very highest rank to the middle of the pack with a two-notch downgrade. A weak economy will mean fewer rail shipments for a company that has already seen a strong decline in coal shipments due to low natural gas and a hostile regulatory environment. Auto and chemical shipments have been picking up the slack so far, but if the economy continues to weaken, rail traffic will suffer heading into next year. My technically oriented friends tell me the stock has a bad chart and should be sold or simply avoided at this level. My view of the U.S. economy tells me the same thing.

Most of the major auto manufacturers have received recent downgrades from the earnings-momentum-sensitive service. Ford (F), Honda (HMC) and Nissan (NSANY) all slipped a notch as far as potential year-ahead performance. Last week Toyota (TM ) came down a notch. Autos have been a pleasant economic surprise this year but consumers appear to be done with their transportation-spending spree. I would not rush to buy the stocks in this group right now. Sales and earnings could fall sharply if we do indeed hit a fiscal cliff in the next few months.

Caterpillar (CAT) recently downgraded earnings and revenue estimates as far out as 2015 and said that economic growth would be anemic for the next several years. With that in mind, I see no reason to own the stock. The research service downgraded the stock by a notch after the downgrade and I expect to see another downgrade as the stock experiences negative price momentum. Based on the single-digit price-to-earnings ratio, the stock appears cheap at first glance but a closer look shows that the shares are trading at an EV/EBITDA ratio of almost 9. My intrinsic value estimate for the stock is in the low $70s, so the shares are still overvalued given the economic conditions. This is one of the world's great companies, but until the shares trade a lot lower it is not a great stock for most investors.

I am not a market timer -- I don't even play one on TV -- but I do see a serious disconnect between the economy and the stock market, and that makes me concerned and cautious. Investors should stay small and move slow as we approach what could be a difficult earnings season. Now more than ever it's a time to react to and not predict market movements.

The Growing Disconnect

Investors must consider which stocks to sell or avoid as the stock market and economy continue to diverge.

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