- - Thursday, April 28, 2011


This past week, the stock market passed a new hurdle. That’s right, after Wednesday’s first-ever news conference by Federal Reserve Chairman Ben S. Bernanke, the Nasdaq Composite Index rallied to close at a 10-year high.

Mind you, that rally occurred even though the Fed upped its inflation forecast for the year to between 2.1 percent and 2.8 percent, from 1.3 percent to 1.7 percent in January, and dropped its annual gross domestic product (GDP) growth rate to between 3.1 percent and 3.3 percent from its earlier view of 3.4 percent to 3.9 percent. In my view, the Fed’s outlook simply was catching up to what many economists already have said and what many businesses and consumers have been experiencing.

Aside from the Nasdaq, the other major measures of the stock market — the Dow Jones industrial average and the S&P 500 — have nearly recovered to levels last seen in May 2008 before the market collapsed in the ensuing nine months.

While corporate earnings have been strong over the past two weeks, a number of companies — including Kimberly-Clark, McDonald’s, Procter & Gamble, Pepsi — have signaled that they are being affected by higher costs for raw materials and purchased goods.

At the same time, gasoline prices are hitting everyone hard, and the economy has hit a soft patch as confirmed by Thursday’s initial take on the first-quarter 2011 GDP. The initial GDP reading came in at 1.8 percent and was far weaker than expected earlier this year.

The question probably entering your mind, and I say that because it has entered mine, is: What’s the next direction of the market?

To me, the data is lining up to say that, best case, the market likely will head sideways after quarterly earnings are completed in a few weeks.

But we are more likely than not going to get a market correction. A typical correction equates to a 10 percent pullback, which would erase most if not all of the market gains year-to-date. As always, I look for confirming signs and, as I mentioned several columns ago, one contraindicator to keep an eye on is the American Association of Individual Investor’s Sentiment Index. For the week ending April 27, that index revealed that of those individual investors surveyed, more are now bullish (up from 32 percent to 38 percent) and more are less neutral on the market (down to 31 percent from 37 percent). Given the shift in those to two choices, we quickly see that 31 percent of respondents remain bearish.

As I mentioned, that Sentiment Index is a contraindicator, which means that as the bullish level rises and the neutral level falls, we should become more cautious.

Again, it’s more of a confirming sign for me. But as many have mentioned, there is always a bull market out there; all you have to do is find it.

One area worth considering is “guilty-pleasure” stocks, a term I use for companies whose products are the little treats and harmless vices that we as consumers like or need from time to time, even though there may be a form of guilt associated with indulging in them. Chocolate, beer, wine, spirits, cigarettes, junk and fast food, gambling and more are typical products from these companies, which tend to have inelastic demand for their products, good cash flow generation and meaningful dividend income on average.

Given the nature of these products, it should come as little surprise that the guilty-pleasure group of stocks held up well during the past two recessions and performed even better on a relative basis when compared to several stock market indexes.

A recent report by Merrill Lynch, which examined the performance of tobacco, alcohol and casino stocks during all recessions since 1970, found that while the broad S&P 500 fell by 1.5 percent on average, the guilty-pleasure group of stocks rose 11 percent on average. During the great tech meltdown, the broad market fell 20 percent from June 2001 to June 2002, but during that time tobacco stocks gained 8 percent and gambling-related stocks nearly 20 percent.

The inelastic nature for these guilty-pleasure products has enabled the companies to weather price increases better than other products and services that are considered to be more of a commodity. Perhaps the best example is the tobacco industry. Consider that while the domestic tobacco business is essentially in a decline as more people are starting to realize the effects of smoking on their well-being and taxes are being raised each year on cigarettes, the levels of price increases that cigarette makers generate more than offsets the decline in consumption by customers.

Given my current concern over the ability to spend amid significant increases in food and gasoline prices — as well as the soon-to-be-felt price increases given recent announcements from Procter & Gamble, Kimberly-Clark, McDonald’s and others — I see the guilty-pleasure stocks as a potential safe haven given not only the nature of their products but also because of their pricing power, strong cash flow, dividends and brand loyalty. At a minimum, it would be prudent to have some exposure to guilty-pleasure companies as part of a well-rounded portfolio.

Good hunting.

Chris Versace, the Thematic Investor, is director of research at Think 20/20, an independent equity-research and corporate-access firm in the Washington area. He can be reached at [email protected] At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.

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