What if it’s all just a bad dream?

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The debt problems in the US and Europe are creating widespread bearish sentiment in stock markets. The interconnection of financial markets is so great that reading investor sentiment has become a little like trying to spot fractals. A Greek butterfly flaps its debt laden wings and a hurricane occurs in the the Standard & Poors. But what happens if things muddle through, as they often do? A Merrill Lynch report askes an interesting question. “What if the debt issues are resolved?” It concludes that the best plays are cyclicals, banks, property developers and health stocks with offshore earnings. Some of these would be strictly trading plays, however.

Based on this analysis there are four ways for investors to position for a bounce. (1) The more cyclical industrials (BSL, OZL, QAN, TOL, and CSR) that bounced the most previously and have attractive valuations. (2) The major banks, which have not suffered as much this downturn, but have valuations that are more supportive than last year. (3) Property developers (FKP and SGP) that have done much worse this time around. (4) Offshore earning health care stocks (COH, RMD and CSL) that have been hurt by the resilient A$.

Merrill Lynch uses three screens to try to pick what any bounce would do: Screen 1 is to look at history:

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Screen 1: Stocks that bounced the most post mid 2010 Given the similarities between the 2010 and current downturns, a good starting point is to screen for companies that benefited the most during the bounce in the first two months (05 July – 15 Sept) after the 2010 trough. The ten stocks that bounced the most were: MQA, EHL, OZL, WSA, FLT, PNA, CTX, IPL, VBA, and PBG.

Screen 2 is picking those that have been adversely affected and which may return to more “normal” valuations:

Screen 2: Stocks that have done much worse this time. Some stocks have done much worse during this downturn as compared to last year’s. Given this underperformance, these companies may have more upside potential during a bounce. We screened for stocks that have underperformed the market during this downturn, but outperformed during the 2010 downturn. The top six stocks that have been the most impacted are consumer discretionary; however, these may struggle going forward due to recent profit downgrades. The next ten are: FKP, GCL, GFF, WPL, GWA, AWC, ABC, PTM, COH, and UGL.

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Screen 3 is stocks with the most attractive valuations:

Stocks are more likely to bounce if they have valuation support. We screened for stocks where the current 12 month forward PE is at least 10% below the forward PE from July 2010. The companies that are trading on the largest discount versus last years’ valuations are: SKI, TPM, BOQ, WHC, SWM, QAN, CRZ, STO, TAH, and FXJ.

Of the three screen 3 is probably the safest bet. And given that there is a high chance that the debt problems will continue in some form, the safest bet is probably also the best bet.

http://www.scribd.com/doc/60500433/Merrill-1

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