Bulls Become Harder To Find

6/11/2012


U.S. stocks have slumped broadly and sharply since early May, and a bounce from today's oversold levels would not be surprising. The extent of any such bounce will be crucial, as a breakout above this year's highs of 13,279.32 in the Dow Industrials and 5,368.93 in the Dow Transports would reconfirm the bullish primary trend under the Dow Theory. With a failed attempt to surpass both those points — and a subsequent breakdown below the pre-bounce lows — the Dow Theory would shift into the bearish camp.

Our stock-market exposure will be reduced with a bear-market signal, but our strategy is not entirely dependent on Dow Theory. Also influencing our asset allocation are investor sentiment, the market's overall valuation level, and the availability of attractively valued stocks. On all three counts, we see reasons for optimism.

Sentiment

Advisers: According to Investors Intelligence, 34.0% of investment newsletters were bullish and 26.6% bearish in early June. Bullishness has dipped to its lowest level since September 2010, and both the bullish and bearish readings lag 20-year averages of 46.2% bullish and 31.0% bearish. A larger-than-normal percentage of advisers believe the market is in a correction stage.

Individual investors: Individuals are also pessimistic, as measured by the American Association of Individual Investors. During the last week of May, 28.0% were bullish, well below the 20-year average of 40.3%, while 42.0% were bearish, well above the historical norm of 30.5%.

Asset-allocation survey: The Bloomberg consensus of equity strategists at major banks calls for investors to keep only 52% of portfolios in stocks. That's the lowest percentage since the first half of 2009.

Mutual-fund flows: According to the Investment Company Institute, about $111 billion flowed out of equity funds in the 12 months ended April, while bond funds enjoyed net inflows of about $263 billion. Not in at least 12 years have stock funds bled so much money over 12 months.

To summarize: Advisers are waiting for direction, individuals are nervous, and investors of all stripes are abandoning stock funds. Patient investors have usually done well buying stocks when bearishness is as rampant as it is today.

Valuations

The S&P 500 Index trades at roughly 13 times trailing 12-month earnings, below the average of 16.4 since 1954, according to Bloomberg. Based on the spread between 10-year Treasury bond yields and the S&P 500 Index's earnings yield, or earnings/price ratio, stocks are nearly as cheap as they have ever been since 1962, according to Bloomberg.

The P/E of the capitalization-weighted S&P 500 Index is being depressed by the modest valuations of its biggest members. On an equal-weighted basis, the average S&P 500 stock trades at 17 times trailing earnings — lower than 93% of the month-ends since 1994 and below the norm of 21. But valuations are not as attractive for the broader market.

To summarize: Stocks are cheap relative to bond yields, but only big stocks are very cheap relative to historical norms.

Attractive stocks

Sales-growth momentum has held up well in recent quarters, but profit growth has slowed amid a dip in profit margins. As shown in the table below, the number of S&P 500 companies posting per-share-profit gains is below historical norms. Still, because P/E ratios are relatively low, the number of attractively valued growers in the S&P 500 is above historical norms.

To summarize: The recent deceleration in earnings growth is grounds for concern, but quality growers are available at reasonable valuations.

S&P 500 GROWTH-AND-VALUE BREAKDOWNS
--- Number Of S&P 500 Companies with Sales Change In Latest Quarter Of: ---
Less Than 0%
0% To 5%
5% To 10%
10% To 15%
15% To 20%
Above 20%
Recent
99
77
104
68
57
94
Norm Since 1994
151
65
73
63
44
94
--- Number Of S&P 500 Companies with
---------------- Per-Share-Earnings Change In Latest Quarter Of: ----------------
Less Than 0%
0% To 5%
5% To 10%
10% To 15%
15% To 20%
Above 20%
Recent
178
42
48
36
34
166
Norm Since 1994
158
34
37
45
40
185
As shown above, S&P 500 companies with sales momentum are relatively plentiful, while historical comparisons are unfavorable based on per-share earnings. As shown below, the percentage of S&P 500 stocks with low P/E ratios exceeds long-term norms, and attractively valued growers are relatively plentiful.
----------------- % Of S&P 500 Stocks With Trailing P/E Ratio Of: -----------------
Less Than 0%
0% To 5%
5% To 10%
10% To 15%
15% To 20%
Above 20%
Recent
8
17
30
23
8
14
Norm Since 1994
4
13
22
19
12
30
NM Not meaningful because of either an operating loss or lack of data.
Number Of S&P 500
Companies With At Least
5% Growth In Sales And
Per-Share Earnings In
--- Latest Quarter And ---
 
Number Of S&P 500
Companies With At Least
10% Growth In Sales And
Per-Share Earnings In
--- Latest Quarter And ---
P/E
Below 10
P/E
Below 15
P/E
Below 20
 
P/E
Below 10
P/E
Below 15
P/E
Below 20
Recent
25
92
160
 
Recent
20
54
101
Norm since '94
16
58
110
 
Norm since '94
11
38
72

 

Conclusion

Much depends on the outlook for corporate profits, as valuations suggest another severe bear market is unlikely if earnings remain on even a modest uptrend. For now, we intend to watch the Dow Industrials and Dow Transports as we look for buying opportunities in individual stocks. Our buy lists have 83% to 85% in stocks.

 


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