U.S. Stocks In Holding Pattern

9/10/2012


With so much stock-market commentary focused on elections and central banks, today's stock market can seem like a complicated way to bet on government action. It's not.

Government policy and the rule of law are hugely important, and history suggests stocks tend to outperform cash when the Federal Reserve is printing money. Don't let the news of the day dominate your decision-making process. Focus on being invested in the best-positioned stocks in your selection universe, setting your exposure to equities based on the market's price action and the opportunities available in individual stocks.

As you consider the big picture, don't put too much emphasis on personalities and political parties. Concentrate on the core drivers of long-term stock returns: earnings, dividends, interest rates, inflation, and valuations.

With U.S. dividend payments at all-time highs, long-term yields on Treasury bonds only slightly above this summer's all-time lows, and the Federal Reserve's preferred measure of inflation expectations near 11-year lows, earnings and valuations represent the most debatable aspects of the bullish case.

Earnings for the S&P 500 Index are expected to decline 2% for the September quarter, the first year-to-year decline since the U.S. recession ended. Consensus estimates for all 10 sectors of the index except financials and telecom have declined since July 1, according to Thomson Reuters, reflecting a rash of earnings warnings.

Earnings for the capitalization-weighted S&P 500 Index have been hurt by some big declines at big companies, especially among the oil giants. But there is no denying that growth has slowed. The median company in the S&P 500 delivered 5.6% growth in per-share earnings in the most recent quarter, the slowest pace since 2009.

Fortunately, valuations suggest investors are not anticipating robust earnings growth. The median S&P 500 company trades at 15.8 times trailing earnings, lower than the 20-year norm of 17.9 and lower than 85% of the months since January 1992.

Conclusion

While stocks are reasonably valued, especially relative to bond yields, a sustained rally may require some improvement in the earnings outlook. Recent action in the Dow Transports has been discouraging, partly because of an earnings warning from bellwether FedEx ($88; FDX). Still, neither the Dow Transports nor the Dow Industrials have broken out of this year's trading ranges, and we are still finding quality stocks with modest valuations. For now, as a partial hedge, our buy lists have 10% to 15% in a short-term bond fund.


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