Look for M&A from U.S. companies in search of a skilled workforce

 

Author: Hengfu Hsu, Analytic Investment LLC

Covestor models: Focus Value, Dividend, Enterprise Value, Deep Value, Opportunistic Value, Earnings Growth

The US equity market put in a bottom on October 5th, the date of Steve Jobs’ death. We mentioned in our previous monthly report the historically volatile nature of October, and after briefly breaking down to the August support level, we indeed witnessed the S&P 500 index put in the best October rally since 1982. The NAAIM active manager sentiment survey had its historically most bearish reading of -3.56 exactly on October 5th, making it the most precise contrarian indicator this time around.

The S&P 500 index rallied 10.77% in October after falling for 5 straight months (data). The VIX lowered significantly towards the end of October – it is a great relief for equity investors that the steep VIX futures contango evident since July is almost over and it has failed to develop into a full blown bear market like the one in 2008.

As of October 31, 2011, US equity market condition is positive based on the following factors we use to manage risk in our models:

(1) Equity Earning Yield Over Treasury Yield (Cheap, Balanced, or Expensive): Cheap
(2) Equity Earning Trend (Up, Sideway, or Down): Up
(3) Credit Risk (Low, Normal, High, or Dangerous): Normal
(4) Equity Volatility (Low, Medium, High, or Dangerous): High
(5) Equity Money Flow (Positive, Neutral, or Negative): Neutral
(6) Yearly Equity Price Trend (Up, Sideway, or Down): Sideway
(7) Monthly Equity Price Trend (Overbought, Sideway, or Oversold): Overbought

While many economists continue to call for a double dip recession in the U.S., the latest economic data point to continuing growth. Q3 US GDP grew at 2.5%, almost twice the Q2 growth rate of 1.3%, and quite a jump from Q1 growth rate of 0.4%. Corporate Q3 report cards are simply astonishing, and S&P 500 companies are on track to make another record quarter. We have not seen the minimum 20% to 40% reduction in earnings that usually precedes a U.S. recession. The overall investing environment and seasonality look positive in the U.S. for the next few months. Current earnings expectations for Q4 are down around 2% to 3% sequentially, but up over 15% year over year. Sequential growth resuming in Q1 2012 and throughout 2012 should make for a better year for the equity market after a turbulent 2011.

In our August monthly report, we mentioned that in order to continue the growth of future earnings, corporations have to deploy their multi trillion dollar cash stockpiles. We indeed saw acceleration of M&A activity in October. For example, on October 24th, two healthcare sector stocks in our Covestor Enterprise Value and Earnings Growth models, HealthSpring (NYSE: NS) and Adolor (Nasdaq: ADLR), became the latest announced acquisition targets, sending their share prices up dramatically on the day.

As we said in our August monthly report, despite the high unemployment rate in US, unfavorably high tax rates, and complicated regulations, the U.S. is facing another serious issue: a lack of qualified, skilled workers for good paying jobs. Since these issues cannot be resolved in the short term, corporations will likely have to increasingly rely on mergers and acquisitions to cut administrative cost and to expand a skilled workforce. This should create good investment opportunities to bring undervalued companies to fair value.

Models Review

In October, expectations of a Q3 earning slowdown failed to materialized, so all our Covestor models remained fully invested based on our computer algorithms. As corporate earnings and revenues continue growing in Q3, our models will remain fully invested this month. The phrase “fully invested” means that our models use up to 100% of cash, as none of our Covestor models use any form of leverage or margin.

Equity investors started taking on more risk in October and started moving money out of dividend paying stocks, so there is no surprise that our worst performing model in October was the Dividend model with a gain of 8.64%. According to Covestor,  the Dividend model is also our only model that underperformed the S&P 500 in October.

We entirely rely on our computer algorithms to buy undervalued stocks and sell overvalued positions, to monitor market conditions, and to manage risk in all models, so that human emotion and buy-sell bias are completely eliminated from the investing process, unnecessary market timing is avoided, and continuous participation in the market is possible in the effort to achieve long-term growth.