Sabrient - What the Market Wants

Dog Days of Summer Turn Rabid

The summer doldrums turned nasty in July with the Dow dropping almost 700 points over four days. Unlike the down market in June, where the smaller caps held their own, in July the smaller you were, the worse you did. And growth continued to trounce value. Strange.

To be fair, the drop in value stocks was probably related to the subprime mortgage debacle, which by now is encompassing the pillars of the value segment of the market: mortgage companies, mortgage-related companies, investment banks, and commercial banks. Other value bastions such as insurance companies and oil companies didn't fare much better.

The small-cap value index lost a staggering 8.6% in July alone. Mid-cap value was down 5.7% and even the Russell 1000 Value Index was down nearly 5%. By comparison, all the growth indices looked more like winners with the Russell 1000 Growth Index losing a mere 160 basis points and the Russell 2000 Growth Index losing 5.2%. Putting it in clearer perspective, the average growth metric was a whopping 300-340 basis points better than its value counterpart. We don't ever recall such a comparison in a severe down month.

In a market like this, of course, all indices were down. The best of the worst was the Dow with a loss of 1.5% and, surprisingly, the Nasdaq Composite was in second place with a loss of 2.2%.

It is somewhat difficult to comprehend the metrics of the current market other than to attribute most of the damage to subprime mortgages and the subsequent fallout from very highly leveraged hedge funds. Comments from industry leaders such as Bear Stearns have been far from reassuring.

There is no easy way to determine when this may turn around, but opportunities abound for bargain hunters. Many companies unrelated to the mortgage or leverage debacle were thrown out with the bathwater. Market liquidity remains high, and short interest is near record levels.

Counterposing these factors however, is extreme leverage in portions of the hedge fund industry and unattractive domestic interest rates. The latter is causing foreign investors -- who have had their own problems in their local markets -- to seek markets other than the U.S.

It is hard to draw a conclusion about the market's preferences, although it seems at least to favor rapidly growing cash flow. Normally, that occurs in some growth stocks, but frankly, it is unusual for growth stocks to do well in an environment like the current market, and therefore we have very few precedents to draw upon.

However, some examples of stocks that have superior one-year cash flow and have rallied amid the recent sell-off include: Eagle Bulk Shipping (EGLE), First Solar Inc. (FSLR), Heartland Payment Systems (HPY), Omniture Inc. (OMTR), Research in Motion (RIMM), and Telular Corp. (WRLS). (Click here for a free look at these reports.)

Government intervention in the mortgage markets could be the catalyst for a market turnaround, as demonstrated on August 6.

Next update: Second week in September.