4 Stock Picks for an Aging Bull Market By Jack Hough February 17, 2018 Photo: Pete Gamlen for Barron’s The bull market for stocks charged through a caution sign this past week in the form of rising inflation, and it appears to have plenty of upside left. But it’s time for investors to think about how and when bull markets end, and what performs well during their twilight years. Groups to favor now include financials, which benefit from rising interest rates, and industrials, especially those tied to commodities, which get a boost from inflation. Technology still looks attractive, but avoid overpaying. Stocks to consider include Alphabet, Lam Research, Citigroup, and Cummins. The prices consumers pay for everything but food and fuel rose a seasonally adjusted 0.349% during January, the Department of Labor said on Wednesday. That’s the fastest core inflation for a single month in more than 12 years. Bonds tumbled in response, sending yields higher, in anticipation of the Federal Reserve getting more aggressive with rate hikes. Newsletter Sign-up Stocks, the traditional view goes, should have sold off, too, because bonds will better compete for investor affection as their yields plump up. But the starting point matters. The benchmark 10-year Treasury yields 2.8%. The Standard & Poor’s 500 index has an “earnings yield”—its price/earnings ratio turned upside down—of 5.7%, which means the spread between stocks and bonds is 2.9 percentage points. Over the half-century leading up to the global financial crisis, this spread was less than 0.6 percentage point, according to Daniel Chung, CEO and chief investment officer at Alger. “Essentially, stocks never fully priced in low interest rates, so it stands to reason that they shouldn’t be hurt by higher rates,” wrote Chung this past week in a note to investors. That buys the bull some room, but how much? It turns nine years old in March, and the S&P 500 has delivered a total return from the bottom of 383%. The average bull market since 1926 lasted nine years and returned 480%, according to First Trust. But more telling than averages are bear market signposts, says Marc Pouey, a stock strategist at Bank of America Merrill Lynch. He keeps watch for 19 of them, of which 13 have already turned up. These include the Fed raising rates by at least three-quarters of a point, momentum stocks outperforming, and growth projections broadly rising. Signs that haven’t been seen yet are credit-tightening, an inverted yield curve, and mutual fund managers holding little cash. Since 1968, bear markets have been preceded by at least 80% of BofA’s signposts, meaning three more would be enough. Yet the bank has a year-end target of 3000 for the S&P 500, implying 10% upside from here. “The late stage of a bull market tends to bring high returns,” says Pouey. That being the case, momentum stocks should continue to shine. Barron’s has taken a cautious view of cash-burning climbers like Netflix (ticker: NFLX) and Tesla (TSLA), but many other investor darlings are cheaper than they appear. Last week, we listed stocks whose prices have dipped while their earnings estimates have climbed (“Ready to Shop? 7 Stocks Merit a Look,” Feb. 10). We could easily have included Alphabet (GOOGL). It’s expected to grow yearly revenues at a high-teens rate over the next few years, and it trades at a premium, although a slim one, even though the stock has doubled since we recommended it just over three years ago (“Google: Time to Buy the Stock,” Dec. 6, 2014). At 21 times projected free cash flow over the next four quarters, it’s only about 7% more expensive than the S&P 500. Tech is broadly attractive now because it has high exposure to a pickup in global growth, and on average, tech companies have strong balance sheets and, hence, limited need to borrow as rates rise. For a much cheaper stock than the dot-com titans, look to hardware, and Lam Research (LRCX), which makes the machines that etch circuits into silicon wafers to make memory chips and more. RBC Capital analyst Amit Daryanani calls Lam the “arms dealer in the memory race,” and reckons it’s worth 15 times estimated earnings for calendar 2018, versus a recent 11 times. His $245 price target suggests 32% upside. Lam has more than doubled since Barron’s turned bullish 3½ years ago (“Lam Research Could Return 20% in a Year,” Sept. 13, 2014). The problem with stocks that carry big dividend yields is that they might trade like bonds, and decline in price as rates rise. The workaround is to find stocks with modest dividends today but plenty of potential for payment growth. One such group, it happens, is positioned to prosper as rates rise. Banks saw their lending spreads get squeezed while rates were at rock-bottom, and could see them expand now. The biggest dividend grower among money-center banks could be Citigroup (C). It doubled its quarterly dividend to 32 cents a share last summer after passing regulatory stress tests, but still yields just 1.7%. JPMorgan analyst Vivek Juneja predicts a further near-doubling, to 62 cents per quarter, by next year. Inflation tends to bring higher commodity prices, and crude oil, gold, and aluminum have all gained since last summer. Materials companies can benefit, but only to the extent they can pass along higher raw materials prices in their finished goods. A recent analysis by Nomura shows industrials have fared better than materials companies since the summer 2016 bottom for the 10-year Treasury yield, which it attributes to their lower leverage, on average. Industrials whose machines extract commodities from the ground would seem particularly well positioned now. We advised readers to take profits in Caterpillar (CAT) just last month after it more than doubled in 2½ years (“With Caterpillar Soaring, It’s Time to Sell,” Jan. 6). But it was a close call. Shares are slightly lower now, and a burst of inflation could easily lead to more gains. Cheaper than Caterpillar is Cummins (CMI), whose engines power vehicles and machines used by truckers, drillers, miners, and others. It trades at 13 times forward earnings estimates, and over the past two decades, it has steadily improved profitability at both the top and bottom of its business cycle. Credit Suisse analyst Jamie Cook counts both Cat and Cummins among his top industrial picks, recently predicting 31% upside for the former and 24% for the latter. Email: editors@barrons.com https://www.barrons.com/articles/4-stock-picks-for-an-aging-bull-market-1518841024