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One vote for a second half rally in the stock market

The unfolding story of the subprime collapse and credit may not be a happy one, says this analyst, but it doesn’t mean things won’t look up.

The story is so familiar, many investors could probably recite it in their sleep (and maybe some do, to the greater consternation of their spouses).

Financial wizards rake in big fees with collateralized debt obligations and other “special investment vehicles,” all kept conveniently off the balance sheet. Subprime mortgage market implodes. Bad credit is splattered everywhere. Giant investment bank Bear Stearns falls to it knees. Stock markets go down, then up, then down. Where will it all end?

How about the second half of 2008, asks Mr. Richard Croft? The mess that’s floating around the credit market won’t be cleaned up for a while yet, he writes in The MoneyLetter, but don’t despair.

A second-half rally is a distinct possibility. This investment counsellor and portfolio manager also has some stock recommendations to update for his readers, and a new pick to unveil.

Sliced, diced and repackaged

Not many of the people who manage investments for a living have escaped unscathed from the credit crisis, says Mr. Croft. “The sliced, diced and repackaged junk infiltrated every corner of the global financial system, so that even fairly sophisticated investors, like holders of Canadian non-bank issued asset-backed commercial paper (ACBP) were burned.”

A few astute people who did their homework and protected their assets, their funds and their shareholders managed to come out ahead.

“But the money managers, funds, banks, insurers and others whose primary function ought to have been the careful husbandry of their investors’ wealth forgot all that,” says Mr. Croft disapprovingly. Those few years of “gargantuan fees and fat yields” made them think they had stumbled upon the goose and the golden eggs.

The crisis isn’t over yet, cautions the author. There’s still a lot of lurking debt that hasn’t been cleaned up. Consumer spending is down in the U.S., the manufacturing and service industries are both contracting and 80,000 jobs were lost in March. But not everything is falling.

“So why isn’t the stock market sliding more rapidly?” asks Mr. Croft. Where’s the bear?

The fear gauge

“Although markets have experienced the kind of volatility I don’t think anyone of this generation has witnessed before,” comments Mr. Croft, “they have arguably not convincingly entered bear territory — that is, a sustained slide of more than 20 per cent from a market top.”

Naturally, the markets corrected pretty severely from last year’s highs, with the S&P/TSX Composite and Dow Jones Industrial Average taking 18 per cent tumbles and the S&P 500 a 20 per cent thud. But they have rallied from those lows.

And there’s another way to measure stock market volatility. The Chicago Board Options Exchange has a volatility index. Officially its called the VIX after its ticker symbol, but it’s also called the “fear gauge,” for obvious reasons.

It has fallen from a high of 37.24 in March to less than 20 late last week. But it is still up from single digits early in 2007. “So no extreme pessimism in sight,” says Mr. Croft comfortingly.

And he takes a message of hope from these signs of relative calm.

Anticipating a recovery

“Right now,” states Mr. Croft, “the market seems to be telling us that stocks are priced more or less fairly, that the earnings outlook, while darkened by the slowdown in the U.S. economy, is not really all that bad, and there’s likely to be a significant rally in the second half of the year, as stocks markets begin to anticipate a recovery in 2009.”

With this light at the end of the tunnel in mind, Mr. Croft has a new recommendation to make and updates on three stocks he previously recommended in The MoneyLetter. We’ll begin with the new one.

Proex Energy Ltd. (TSX-PXE) is certainly not one of the better-known beneficiaries of the energy boom. But this oil and gas firm has a distinct advantage, in the author’s opinion. Although based in Calgary, “it operates exclusively in northeastern B.C., and as a consequence is insulated from the Alberta provincial government’s misguided hike in royalty rates.”

It produces more than 13,000 barrels of oil equivalent per day, although cold weather kept its production down in the first quarter. The company has a strong program of exploration, acquisition and growth — most critically, it was able to replace no less than 553 per cent of proved reserves in 2007. Proex is ready to benefit from the rising demand for natural gas. Buy, says Mr. Croft.

If you’re looking at gold stocks, says the author, look at Goldcorp Inc. (TSX-G). “As a disciplined, low-cost producer, Goldcorp has benefited greatly from the surging price of gold,” observes Mr. Croft. “If you’re going to put only one gold major in your portfolio for the long term, this is the one.” It’s a hold/buy.

Stay the course

Finally, Mr. Croft updates two U.S. recommendations. One is the Big Blue Machine (in this case meaning computers, not Conservatives).

International Business Machines Corp. (NYSE-IBM) has done well by the weaker U.S. dollar. International sales get a boost from the lower greenback and earnings jumped 26 per cent year over year. All of its business units showed greater profitability. “There’s still more upside to come,” says Mr. Croft. Still, it’s not a buy right now, since business technology spending is bound to be a bit soft. But if you’ve got it, hold it.

For the same reaons Cisco Systems Inc. (NASDQ-CSCO) is a hold. But even in a soft spending environment, this company is the dominant player in the Internet switching business and has a long history of success in acquiring and running complimentary businesses. If you have this one, stay the course.

In fact, that essentially sums up the message Mr. Croft has for his readers in The MoneyLetter. Stick with it. The stock market has stared the bad news squarely in the face, taken its lumps and staggered back to its feet. If it’s ready for a rally, you should be too.