For Now, Trend Still Your Friend

11/4/2013


The Dow Industrials rallied above their Sept. 18 closing high of 15,676.94, reconfirming the bullish primary trend under the Dow Theory. With nearly all major U.S. averages and advance-decline lines at all-time highs, the market's trend is not in question. The question is what you are going to do about it. Among your options:

1) Do what you've been doing, since changing course would require decision-making in a highly uncertain environment.

2) Get while the getting is good. The median large-company U.S. stock trades at premium price/earnings ratio relative to 20-year norms, and midcap and small stocks are even more expensive. Also, selling now means not having to worry (so much) about profit shortfalls, flash crashes, and debt ceilings.

3) Of the portion of your portfolio allocated to equities for the long haul, hold 94% to 98% in stocks.

If you've been following our advice, option No. 1 gives you the right answer for the wrong reason. It's a mistake to let your desire to avoid decisions dictate your portfolio strategy. While limiting portfolio turnover and avoiding the temptation to trade on news are generally worthy aims, there is no such thing as passive investing. Whether you keep all your money in cash or index funds or our Focus List, every day you are making a choice about where to put your money.

Option No. 2 may be the right choice if you've reached your financial goals. But we still expect stocks to outperform bonds and cash over the next year, partly because we expect corporate profit growth to accelerate — and partly because the bull market could be entering a final speculative phase.

Dow Theorists divide bull markets into three phases. In the first, confidence in the future of business revives and stocks rebound from discounted levels. In the second, stocks respond to rising earnings and dividends. In the third, rampant optimism and speculation push stocks higher on hopes and expectations. Historically, some of the market's best gains are seen in the third phase.

Have we reached this speculative third phase? Answering that question with precision is impossible. Sentiment surveys, option prices, and mutual-fund inflows suggest bullishness is close to the highs of recent years. But stocks are not outrageously valued, and the recommended equity allocations of Wall Street strategists are still below long-term norms.

Conclusion

For our money, No. 3 is still the best option. The broad market appears somewhat expensive given today's modest profit-growth rates. But we are still finding reasonably valued growers, and the bullish reaction to September-quarter results suggests investors see improved growth on the horizon.


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