Don't Lose Your Head

1/9/2012


Getting swept up in the optimism of a new year is an easy thing to do, especially when both U.S. stocks and the U.S. economy are gaining traction. So, now seems a good time to ask five questions level-headed investors should be asking themselves year-round:

What is the primary trend? By closing above the October highs, the Dow Industrials and Dow Transports reached five-month highs and put the Dow Theory in the bullish camp. A move above the October high of 1,285.09 in the S&P 500 Index would provide additional evidence of an uptrend, and a breakout in the averages above the post-2009 highs reached last year would leave little doubt regarding the market's trend.

What is the outlook for inflation and interest rates? The Federal Reserve says it expects to keep short-term interest rates near 0% until at least mid-2013, and prices in fed-funds futures markets indicate investors expect the Fed to remain on hold until late 2013 or early 2014. A jolt of unexpected inflation could upset these expectations, but wages and commodity prices point to continued subdued inflation.

Are investors unusually optimistic or pessimistic? When sentiment is especially optimistic, it suggests investors have already loaded up on stocks — and the market will be particularly vulnerable to any bad news. With the percentage of bullish newsletters near eight-month highs, and the percentage of bullish individuals back above long-term norms according to the American Association of Individual Investors, sentiment may be getting a bit exuberant on a short-term basis. But considering the fairly bleak sentiment revealed in consumer-confidence surveys and continuing mutual-fund outflows, it is hard to argue sentiment has reached a bullish extreme.

Are stocks cheap? As shown in the chart below, the average S&P 500 stock is cheap versus 20-year norms. While the broad market is not as cheap as the big stocks in the S&P 500, we face no shortage of attractively valued growers.

What is the outlook for earnings? Stocks discount the next decade or more of earnings, but what happens over the next 12 months will have an outsized effect on long-term profit expectations for profits. Heading into December-quarter reporting season, the number of profit warnings has jumped close to 10-year highs. Once earnings season gets in gear in mid-January, the outlook for year-ahead profits should become clearer.

Conclusion

More often than not, questions lead to more questions. But, all things considered, we see more reasons to be bullish than bearish. For now, our buy lists hold 85% to 88% in stocks, with the remainder in a short-term bond fund.


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