Sell-Off Raises Questions

5/28/2012


At times of stress it makes sense to refocus on the basics, and our recommended stock-market exposure depends mostly on the answers to four basic questions:

What is the primary trend of the stock market? Significant corrections typically retrace one-third to two-thirds of the preceding advance, and both the Dow Industrials and Dow Transports have suffered such declines. That means a rebound that fails to bring significant highs in both averages would set the stage for a bear-market signal. The low points that would trigger a bear-market signal have not yet been established, while moves above 13,279.32 in the Industrials and 5,368.93 in the Transports would reconfirm the bullish primary trend.

Are stocks cheap? Valuation ratios like price/earnings are very imprecise market-timing tools. But they provide valuable perspective, as market tops typically occur when stocks are expensive. The S&P 500 Index trades at less than 15 times trailing earnings, versus the norm of 17.4 since 1945.

The median stock in the S&P 500 has a trailing P/E of 15.2 — below the norm of 18 and lower than all but 10% of the month-ends since 1994. On average, stocks in the broader S&P 1500 Index are not as cheap as those in the large-company S&P 500. But unless you expect corporate earnings to turn lower, calling the market richly valued seems a stretch.

Are investors fearful or greedy? Historically, buying when investors are down on stocks has been a winning strategy. Judging by mutual fund outflows, the average retail investor is downright bearish. Domestic equity funds have seen outflows for 12 consecutive months. The outflows have more than offset inflows into domestic exchange-traded equity funds, which in April saw their first outflows since the summer of 2010.

The percentage of bullish investment newsletters has dropped to a fairly neutral reading of 38%, down from 57% in April, according to Investors Intelligence. Among Wall Street strategists, the recommended allocation to stocks has dropped to 52%, the lowest percentage since the market bottomed in March 2009.

Are quality stocks available at good prices? We see no shortage of well-positioned growers with modest valuations. Less subjectively, 205 stocks in the S&P 1500 with trailing P/Es below 15 delivered at least 5% sales and per-share profit growth in the most recent quarter — above the norm of 164 and higher than 77% of month-ends since 1994.

Conclusion

The weight of the evidence suggests a healthy allocation to stocks remains appropriate, but we intend to raise more cash if the primary trend turns bearish. For now, our buy lists have 84% to 87% in stocks.


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