5 standout stocks amid a June swoon

The yield on the 10-year Treasury would have to climb to 5.7% to reduce the gain for the rest of 2007 from the June 4 close, prior to last week's three-day slide, to 5%.

I think that kind of interest-rate move in the remainder of 2007 is extremely unlikely. Something truly unexpected would have to happen to produce that kind of spike in yields. And that's why I feel reasonably confident that a broad market index like the S&P 500 will finish 2007 ahead of its June 4 level.

Higher rates anticipated

But the Federal Reserve model is better at indicating fair value when interest rates are steady than when they're climbing or sinking. Fair valuation can sink below the levels indicated by current yields if investors think interest rates will continue to climb. And that's exactly where I think we'll be at the end of 2007. The yield on the 10-year Treasury is likely to be no higher than 5.5% by the end of 2007, but investors are already starting to talk about interest rates much higher than that.

Bill Gross, managing director at money manager Pimco and the single most influential voice on the bond market, recently raised the top of his three- to five-year forecast to 6.5% from 5.5%. Stock market valuations are likely to be lower than a static Fed model predicts because investors are anticipating yields of 5.8% or so in 2008.

Stock market history gives us a pretty good idea of what sectors underperform the general stock market when interest rates are on the rise. Utilities suffer, since investors buy these stocks for their yields and higher bond yields make utility stock yields less attractive. Banks and other financials suffer, since higher interest rates increase the cost of raising the money that they lend and often cut into loan demand. Real estate suffers, since higher interest rates raise mortgage costs and decrease the number of people who can afford to buy.

Lots of squeezing likely

This time around, though, I think investors should add some other groups to the list of likely underperforming sectors. That's because rising costs for raw materials are, in some sectors, putting a big squeeze on profits. In my previous column, "How ethanol bites you in the wallet," I laid out the case for a profit squeeze in the food sector. I'd avoid that sector for the rest of 2007.

Transportation faces its own squeeze from higher fuel costs. Retailing will struggle because of a combination of higher costs (for everything they sell, as well as the transportation to get it to stores) and lower sales, as interest rates and gas prices climb.

So where do you look for outperformance for the rest of 2007? Energy, of course, where a cascade of higher earnings overwhelms worries about costs. But even better: capital goods. The makers of the machines that help companies get their jobs done have been a key beneficiary of higher prices, because so many companies in these sectors have gone out of business or have been acquired that customers can't pit one supplier against another. If you want a fuel-efficient, long-distance jetliner because rising jet fuel prices are threatening to drive you out of business, you have to buy from Boeing (BA, news, msgs). If you want to expand mine capacity because the price for everything from coal to copper is so high, you have to knock on the door of Joy Global (JOYG, news, msgs) or its two major competitors, since a 20-year slump in the mine-equipment business drove everybody else out of business.

Continued: Five stocks to add

< previous |  1 | 2 | 3 | 4 | next >