Read This If You Don’t Own Equities

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Dow Jones Industrial Average has set a new market high and the S&P 500 is within 1% of its record as well. Yet the bearish pessimism continues to permeate through the media as if every time an asset hits a new record high there must be an artificial bubble that is about to burst. What isn’t usually mentioned is that these new highs are following the worst decade (2000-2009), at least based on the S&P 500, in the modern area. The average annual return for the S&P 500 was a NEGATIVE 1% during the last full decade and trailed even the Depression area 1930s. Think about that for a second. This perpetual pessimism is the wall of worry that propels stocks higher and this year is a continuation of what occurred in 2010, 2011, and 2012.

Crashing correlations

The exchange-trade fund has become commonplace during the last decade and continues to gain market share relative to individual equities on an annual basis. There are valid reasons for owning such securities, but don’t be fooled into thinking it is because all stocks move in the same direction. The Great Recession brought about the phrases “risk-on” and “risk-off” as market pullbacks saw the correlation of S&P 500 stocks relative to the Index surge into the 80% range. ETFs allow investors to get into and out of the market with substantially lower transaction costs. But with the market poised to start a long ascent, owning the right securities and trading less frequently offers enormous potential. The correlation for S&P 500 stocks relative to the Index is now down to 59% and previous bull markets have seen this drop into the 30% range. During the 1990s it actually got into the low 20% area. What does this mean? Stock picking is poised to make its return this decade.

The drop in correlations among stocks and industries is clearly evident as we progress in 2013. The largest sector, Information Technology, has produced the lowest returns. The weakness has been broad-based with only 3 of the 12 largest companies outperforming the S&P on a year-to-date basis. The biggest culprit is Apple (NASDAQ: AAPL) which has booked double-digit losses thus far. I highlighted some risks related to the stock at the start of the year and my anticipation for first half weakness, while worse than anticipated, is playing out. The bullishness surrounding the name has started to wane and will eventually position the stock for positive returns, but the timing remains a guess. According to Factset, the 50 largest hedge funds reduced their exposure to Apple by 31% to end the fourth quarter with an average portfolio allocation of 1.3%.

Patient long-term investors should still feel comfortable owning an industry leading company operating with secular growth tailwinds for just 10 times trailing earnings. The free cash flow yield is off the charts for a company with such visible growth prospects.

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AAPL Free Cash Flow Yield data by YCharts

Another sign of dropping correlations is the weakness exhibited by the Materials sector. Usually a favorite during risk-on phases, this sector has underperformed by almost 4% year-to-date. Correlations have started to come off the 25-year highs that have persisted during most of the recent equity bull market. Chemical companies, such as Praxair (NYSE: PX) have done an excellent job operationally. Unfortunately, this is more than reflected in premium valuations. These companies are going to need more than just a rising market to outperform; they are going to need to beat already elevated expectations.

The EV/Sales ratio for Praxair is at ten-year highs.

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PX EV / Revenues TTM data by YCharts

And a similar story exists for the entire chemical industry with elevated EV/Sales ratios.

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Hopeful on housing, but who wins?

I am firmly of the view that housing, having made a huge run off historic lows, has enormous upside over the next several years. Housing busts are always followed by recovery and then a long bull phase that likely will overshoot historical averages before a notable correction takes place. Is Home Depot (NYSE: HD) that best way to play this outlook? The stock has more than doubled the S&P 500 Index since the market lows of 2009. Results have been outstanding for sure, but with the price-to-earnings ratio blowing past previous highs it becomes purely an earnings growth story. Multiple expansion seems highly unlikely from these levels.

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HD PE Ratio TTM data by YCharts

Or is Wells Fargo (NYSE: WFC), a leading bank with a sizeable position in residential mortgage origination. Wells Fargo stock has been a great performer as well, but much of this upside came during the peak fear moments of early and mid-2009. Home Depot is expected to grow EPS in the 12-15%, or roughly twice that of Wells Fargo. But as can be seen by the extremely depressed price-to-book ratio for Wells Fargo, there is plenty of upside potential from multiple expansion.

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WFC Price / Tangible Book Value data by YCharts

Or is it another company with leverage to the industry that is currently being overlooked by investors?

The Foolish bottom line

What did the market do following the 1930s weak decade? It produced an average ANNUAL return of 8.9% during the 1940s and then 19.2% during the 1950s! Bear markets in the 1960s and 1970s would set the stage for the Great Bull Market of the 1980s and 1990s where average annual returns in the S&P 500 exceeded 17%. It shouldn’t surprise anyone that the super bull was followed by the recent dismal decade. This is how markets work- Bull, Bear, Bull and often in similar magnitudes. Thus far in the current decade the S&P 500 has produced returns of 15%, 2%, and 16%. 2013 is off to a great start as well. Looking ahead, do investors currently reside in a similar situation as investors did in 1943 or 1983? Most of you likely doubt such a scenario and this is exactly why I continue to look for individual equities capable of huge returns during the next secular bull market.

Justin Carley has no position in any stocks mentioned. The Motley Fool recommends Apple, Home Depot, and Wells Fargo. The Motley Fool owns shares of Apple and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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