How To Play The Bull Market

2/4/2013


The market's primary trend is not in question. With the Dow Industrials at their highest level since 2007 and the Dow Transports at all-time highs, the Dow Theory is squarely in the bullish camp. Broader market indexes are at multiyear or all-time highs, and advancing stocks have outnumbered declining stocks by a wide margin in the rally since mid-November.

The question, in our view, is how you should play the bull market. Should you: (a) deploy your remaining cash reserves; (b) let the opportunities available in individual stocks determine whether you are fully or nearly fully invested; or (c) look for a pullback since the market has come so far so fast?

Our answer is all of the above: We're taking our Buy List's stock-market exposure to 96.8% because we want to add J.P. Morgan Chase ($47; JPM), but we're worried about a secondary correction and intend to dispose quickly of stocks we no longer view as top picks. Our Long-Term Buy List has 91.2% in stocks. Our posture, as usual, mostly reflects four considerations:

The Dow Theory is not much help in timing secondary corrections, but it does provide some guidance on their potential magnitude. A typical one-third to two-thirds retracement of the rally since mid-November would put the Industrials at 13,500 to 13,000 and the Transports at 5,550 to 5,220.

Valuations suggest stocks are neither particularly cheap nor particularly expensive, with the median stock in the S&P 500 Index trading at a 6% discount to 18-year norms based on trailing P/E ratio. Small and midcap stocks trade at slight premiums to long-term norms.

Sentiment numbers suggest investors have become a bit exuberant, with surveys of individual investors revealing a jump in the percentage of bulls. Likewise, inflows into mutual funds and exchange-traded funds have surged in 2013. Bullishness among investment newsletters has also jumped, with the percentage of bulls now exceeding the percentage of bears by more than 30% — historically a sign of excessive optimism, according to Investors Intelligence.

• Our Intermediate potential risk indicator, based on the percentage of New York Stock Exchange stocks trading above their 200-day moving averages, has jumped to 82% — higher than 92% of the daily observations since January 1989. Historically, a reading above 70% has indicated a higher-than-normal risk of a secondary correction.

Conclusion

A near-term correction is possible, but we expect stocks to move higher this year and are maintaining a mostly invested posture. Magna International ($53; MGA) offers a top pick for new buying.


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