Batten Down The Hatches A Bit

5/14/2012


We don't like the way things are going. We don't like the way stocks are getting hammered on minor earnings shortfalls and hardly responding to better-than-consensus results. We don't like the way the debt crisis in Europe is again dominating the headlines, or the way bond yields, commodity prices, and stock prices are again moving in lockstep. We don't like the way the Dow Industrials and Dow Transports have diverged since early February, with the Transports unable to confirm a series of new highs in the Industrials.

MEDIAN VALUATIONS AND GROWTH RATES
S&P MidCap
---- 400 Stocks ----
S&P 500 Stocks
---- (Large Cap) ----
Largest 50 Stocks
---- In S&P 500 ----
Recent
Median
Norm
Since '94
Recent
Median
Norm
Since '94
Recent
Median
Norm
Since '94
Trailing P/E ratio
17.3
17.8
15.9
18.0
15.0
20.5
Dividend yield (%)
1.1
0.7
1.8
1.5
2.4
1.8
Sales change last qtr. (%)
8.0
6.6
8.9
6.1
6.3
7.7
EPS change last qtr. (%)
9.6
9.2
6.9
9.9
12.7
12.7
Quadrix Value
53
58
57
59
61
51
Quadrix Momentum
54
51
51
49
61
52
Quadrix Overall
59
61
60
61
80
68

We are reducing the stock-market exposure of our buy lists slightly, partly to reduce risk. Our Buy List now has 9.9% in a short-term bond fund, versus 14.6% for our Long-Term Buy List. We are reluctant to reduce our stock exposure more significantly in the near term, for three primary reasons:

Timing secondary corrections is very difficult, and recent action has been consistent with a correction in a bull market. For the Industrials, a typical one-third to two-thirds retracement of the Nov. 25-to-May 1 advance would mean a pullback to a range of 11,900 to 12,600 — about 2% to 7% below current levels. For the Transports, a typical retracement would bring the average to 4,800 to 5,100 — 1% to 7% below current levels.

Corporate earnings growth has slowed but not stopped, and valuations appear reasonable. As shown above and charted below, the median stock in the S&P 500 Index has a trailing price/earnings ratio of less than 16, versus a norm of 18 since October 1994. The largest 50 stocks in the S&P 500 look particularly attractive.

Relative to bonds, stocks appear very cheap. The median S&P 500 stock yields 1.8%. By comparison, Vanguard Short-Term Investment-Grade ($10.77; VFSTX), the bond fund we use for the short-term reserves of our buy lists, yields 1.6%. We could get a higher yield by taking on more credit risk, and we may go that route if it looks like we are headed into an extended stock-market downturn. But yields on junk bonds recently hit an all-time low, so reaching for yield could backfire for those with short-term holding periods.


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