5 buys for a fourth-quarter rally

By Jim Jubak

I can give you five reasons to expect a fourth-quarter rally this year.

• The market has rallied in mid-August to early October, during what is usually a weak period, to give stocks momentum in November and December.

• Money is flowing out of real estate and bonds and into stocks.

• Short-interest climbed to multiyear highs on both the New York Stock Exchange and the Nasdaq in September, so there's plenty of pessimistic money to send prices higher when it turns optimistic.

• We're starting to see rotation out of the stocks in the Dow Jones Industrial Average Index ($INDU), which led the market upward in September, and into the more speculative Nasdaq stocks that typically lead a fourth-quarter advance. On Oct. 4, for example, the Dow industrials climbed 1.05%, but the Nasdaq Composite Index ($COMPX) rose 2.1%.

• Thanks to an end of tax-selling in October, the stock market almost always goes up in November and December -- 16 out of the past 18 years, in fact.

I suggested in my previous column, "Use beta to ride the next rally," that you increase your portfolio's exposure to a fourth-quarter rally by increasing the beta of the stocks in your portfolio.

Beta measures how well an individual stock is likely to match the ups and downs of the market as a whole. Stocks with a beta of 1 are as volatile as the market as a whole. Stocks with betas above 1 move faster than the market as a whole.

If the stock market as a whole is headed up, you'd certainly like to raise the beta of the stocks in your portfolio to capture that general advance of the market. No laggards wanted here.

But getting the big trends right and tuning your portfolio to the ups and downs of those big trends is only part of the investor's task and only part of what makes up a portfolio's return. The other part is called "alpha" in current financial theory. You and I probably call it stock picking.

Alpha is the part of your return above what you'd get from just tracking the market or a specific index. Delivering alpha is what money managers get paid for. You can, after all, capture the market's return by buying an index fund such as the Vanguard 500 Index Fund (VFINX) and pay a minuscule 0.18% in fees.

It's tough to deliver alpha consistently. In fact, some academic studies say it's impossible to beat the market over the long term and generate any alpha at all. And the effort to produce market-beating returns can get a portfolio in deep trouble. The $6 billion lost by a hedge fund run by Amaranth Advisors in September on a leveraged bet that natural-gas prices would climb -- they fell instead -- is just the latest and most spectacular example of piling up risk in an attempt to produce market-beating returns.

The chase for alpha doesn't have to end like that, I believe. Good stock picking can give you a shot at outperforming the market. At the same time it can limit your potential for losses if the big trends -- and the market as a whole -- go against you.

How? By picking stocks that not only are positioned to take advantage of the big, market-wide trends, but also have their own internal catalysts. These catalysts -- a new product rollout, increasing profit margins, gains in market share and the like -- can keep a stock ahead in a rising or falling market.

The easiest way for me to explain exactly what I mean is to pick five stocks with the right stuff for the fourth-quarter rally: betas above the market beta of 1 and potentially high alphas thanks to internal catalysts that will deliver higher-than-expected earnings. I've listed them in alphabetical order.

Amdocs

Catalyst: Solid progress on key Sprint Nextel (S, news, msgs) account and growing order backlog set to pass $2 billion milestone in December.

Beta: 2.5. In the long term, Amdocs (DOX, news, msgs) is a play on the increasing complexity of customer management in the telecommunications business. The more accounts telecom companies link together, the more services they add, the more pricing plans and billing options they offer, the more they need the customer-management software systems Amdocs provides. In the short run, however, two positive developments should push the stock higher in a year-end rally. First, Amdocs is making solid progress on building out the infrastructure for the big and very complicated Sprint account. Success at Sprint will give Amdocs increased ability to sell systems to other customers. Second, Amdocs's order backlog continues to build and it is likely to pass $2 billion by the end of December. That would demonstrate to investors that business momentum continues to build at Amdocs.

American Eagle Outfitters

Catalyst: Strong mall traffic for fall and holiday shopping seasons plus launch of new store concept MARTIN+OSA.

Beta: 1.49. Mall traffic started strong in the September back-to-school period, in itself good news. Plus, a strong September usually leads to a strong holiday season for retailers.

The news was especially good for American Eagle Outfitters (AEOS, news, msgs), which sold residual seasonal merchandise without resorting to deep markdowns. That's a sign that the company's improved markdown technology works. That should continue to drive operating margins, already ahead of most of its teen-apparel retail peers, up another 0.9 percentage point in fiscal 2007, according to Standard & Poor's. The company has also finally rolled out its new MARTIN+OSA store concept with a single store in the Tyson's Corner mall in Virginia. Three more openings are scheduled for 2006. The revenue from four stores won't amount to much, I admit, but adding a second concept and a new market segment (25- to 40-year-olds) to the company's existing business answers the question of where future growth will come from

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