Three wishes for successful stock picking

The genie granted the equity market three wishes.   The first wish was that the recovery is gaining strength, unemployment is falling, payroll and new home sales rising.   The trouble with this scenario is that Bernanke and Co are likely to put the bung firmly back in the bottle by swiftly raising interest rates. 
 
Equity dividend valuation models used by analysts are extremely sensitive to interest rates.  For example, let’s assume if the dividend yield on an index is 2 per cent, dividends are expected to grow at 5 per cent and shareholders expect returns of 7 per cent. The simple dividend discount model suggests that if you now increase rates by 1 per cent then that index will be overvalued by a third.  Well that doesn’t sound appealing, does it?
 
Perhaps we should use a second wish. One in which growth falters and central governments continue to issue debt, thereby sending bond rates ever higher. Sounds a bit like Europe doesn’t it and we know how that is playing out for falling stock prices.
 
Final wish is one of falling interest rates. Oh dear, this is perhaps the worst. This is Japan for the last two decades.  Wickedly low growth, ultra low interest rates and the bad genie of deflation.   Let’s put the wicked genie back in the bottle and tie on the bung for the time being. It’s certainly no wonder the equity markets are volatile at this crossroads.
 
So stocks will be volatile for some time both to the upside and downside.  However that means there will be opportunities to pick up stocks which have been punished for the wrong reasons.
 
How does one look for stocks such as these?  Professionals do this by running quantitative analysis models which attempt to isolate incorrectly priced assets. But as one famous investor once said,
 
“I got some of my best ideas at the mall with my wife”. Ideas can even come from your bathroom cabinet. Take Procter and Gamble (PG US). I bet you have half a dozen products in your home are made by them:  Charmin, Crest, Olay, Gillette and Pringles to name but a few. Logical to think that we can’t cut back on many of these products no matter what happens to the economy. Could be a defensive play, perhaps. Ideas are everywhere. Have fun looking, you might just come across a good under-valued idea and who needs genies anyway.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.

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Stock Watch by Butterfield Bank’s Steve Evans

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