What could today’s markets have in common with the environment of the late 1970s? Stagflation, for one—a southbound economy paired with a rising cost-of-living—a phenomenon that reigned between 1976 and 1980.
The 1970s saw soaring oil and food prices, bank failures, record trade deficits, declining consumer liquidity, rising interest rates, and imbalanced currency markets, to name a few.
Our dilemma today is undoubtedly similar but differs in significant ways.
Today’s economies and financial markets are far more institutionalized and internationalized, spawning a host of derivatives and financial innovations. We have instant access to information not easily accessed in the 1970s. Our stock market is far more mature—up 17-fold in 30 years—and inflation is no longer driven by labor unions’ automatic cost-of-living clauses.
But the meltdown in the banking and financial community is far worse today. And, while the economy was weak in the 1970s, it was not in a recession. Today’s corporations are far more tech-oriented; back then, basic industry companies were emerging, ranging from service, entertainment, and publishing to real estate, food service, and manufacturing.
Especially exciting then was the fact that between year-end 1976 and February 1980, the NASDAQ Composite Index and Standard & Poor’s Low-Priced Stock Index soared 79% and 160%, respectively, compared to a 10.5% decline in the Dow Jones Industrial Average and a 10.6% rise in the Standard & Poor’s 500 Composite.
Hot secondary stocks in the 1970s are but a distant memory to investors today. To mention a few: Cox Communications, Lear Siegler, Comsat, Viacom Inc., Curtiss-Wright Corp., Kirby Exploration, Culligan, 20th Century Fox, Servomation Corp., American Standard, Amdahl Corp., and Gerber Scientific.
Today, after an initial bounce from all stocks off the bear-market lows, some groups will trade sideways, while new leadership will emerge during what is likely to be a stagflation environment. Under such conditions, odds favor that leadership may come from the small and mid caps, whose ability to navigate adverse economic conditions is superior in many ways to the lumbering blue chips.
According to the official score keeper of market seasonality, The Stock Trader’s Almanac, small caps tend to lead the charge coming out of bear markets. What’s more, they tend to outperform the big blues between mid-December and March. For years, this phenomenon began in January, dubbed the “January effect,” and reflected reinvestment after the turn of the year.
Anxious to get ahead, investors now appear to be buying in December. Thus, if the bottom comes in October, as it has in the last four bear markets, the odds would be skewed even more to small company leadership. In the event that a two-tier market arises from the ashes of the current bear market, investment professionals have many ideas about how to participate.
John D. Fox, director of research for FAM Value Fund, believes his value investments will run against the tide in a stagflation environment. He likes Brown & Brown Inc. (NYSE: BRO), a property and casualty insurance broker with nationwide coverage. Brown sports a reputation as one of the best-managed companies in its industry, posting double-digit earnings growth for 14 straight years.
“The average insurance broker has a 25% EBITDA margin, and Brown tops that with 35%,” Fox explains, adding that its operations create substantial free cash flow that can be used for timely acquisitions. A competitor with much lower margins was recently acquired by another company at a multiple that, if applied to Brown, would come to $25 a share, 47% above Brown’s current price of $17.
Fox also likes Mohawk Industries Inc. (NYSE: MHK), one of just two dominant manufacturers of carpets in the United States. “We estimate it throws off $600 million in cash from operations but only needs about $225 for capital expenditures, leaving $400 million in cash flow,” Fox says. With 68 million shares outstanding, he reasons, that works out to more than $5 share. “With the stock in the 60s, you are getting a 10% cash-on-cash yield if you bought this company in its entirety.”
Jeffrey Hirsch of The Stock Trader’s Almanac says IMAX Corp. (NASDAQ: IMAX) is one of those prototypical stocks that Wall Street loves to love. A highly recognizable brand with a cutting-edge technology, the company has embraced a 3-D platform that led to the success of its 2004 release, The Polar Express.
“Digital projection is the next catalyst for IMAX,” Hirsch says, “and may prove to be the seminal event in the future of the company, eliminating the costly printing, shipping, and handling of film, which should increase the incentive for film studios to release films in the IMAX format.” Up slightly from his recommendation, Hirsch recommends that investors buy as much under $8 per share as possible.
Hirsch also likes (and owns) Headwaters Inc. (NYSE: HW) as an alternate energy play. Headwaters is the largest provider of technology and proprietary organic reagents to the coal-based synthetic fuels industry. Additionally, the company develops breakthrough technologies designed to enhance refining efficiencies and heavy oil upgrading, advanced emission control for power plants, coal liquefaction, and the development of a new generation of nanocatalysts.
Peter Leeds of pennystocks.com believes Hi-Tech Pharmacal Co. (NASDAQ: HITK) is ideally positioned for stagflation. A producer of generic prescription, over-the-counter, and nutritional products, Hi-Tech is experiencing strong growth and sports an attractive pipeline for future results. “In a stagflation environment, I think people are turning toward ways to save money, and this is a good way,” Leeds says, adding that Hi-Tech’s products are not at all discretionary. Leeds likes it under $12 a share, and sees a move to $16.50 within the next year.
He’s also excited about GreenHunter Energy Inc. (AMEX: GRH) for its involvement in the renewable energy areas of wind, biofuels, biomass power, and solar energy. The company was formed to assemble a portfolio of renewable energy and clean fuels assets to address a market worth $650 billion. It has six wind projects in operation and has acquired an interest in MingYang Wind Power Technology Co. in China. Following its IPO in 2007, GreenHunter surged to $25.45 in May before profit-taking and a crunch in the stock market brought it to $12.
Greg Guenthner, editor of Penny Stock Fortunes, seeks companies that are ahead of the curve, and thus present substantial potential rewards. For this reason, he likes Ener1 Inc. (AMEX: HEV), a developer of lithium-ion batteries for hybrid-electric vehicles, fuel cells, and nanotech-related manufacturing processes. Ener1 recently announced it had successfully installed and tested a lithium-ion battery pack for a Think City electric vehicle. In July, it received the prestigious R&D 100 Award for excellence in technology.
“Ener1’s batteries stand apart from other lithium-ions in that they are lighter, don’t get as hot, and don’t need heavy cooling systems, which improves gas mileage,” Guenthner explains. Local governments are buying vehicles like this for meter maids and other services that don’t require excessive speeds. Hybrids using Ener1’s battery have shown a fuel economy of up to 72 mpg, in contrast to 45 to 55 mpg for comparables.
The similarities between 1976-1980 and today are no guarantee that small- to mid-cap stocks will sizzle when the dust settles after the bear goes into hibernation. However, the best time to prepare for a new bull market is before it begins, and if history does indeed repeat itself, you’ll want to be in smaller companies.
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