Bullishness At Extreme Levels

1/6/2014


Our recommended exposure to stocks hinges mostly on four things: (1) the market's primary trend, based on our interpretation of the Dow Theory; (2) the market's valuation, which can provide perspective on whether a bull or bear market is in its early or late stages; (3) investor sentiment, a useful contrarian indicator at extreme levels; and (4) the opportunities available in individual stocks.

Today the Dow Theory is squarely in the bullish camp, as both the Dow Industrials and Dow Transports reached all-time highs on Dec. 26. The broad market is also trending higher, with advance-decline lines and indexes of small, midcap, and large stocks reaching new highs.

The market's valuation is somewhat stretched but not unreasonable, especially considering today's low inflation rate and meager bond yields. The S&P 500 Index trades at 15.3 times expected year-ahead earnings, above the 10-year norm of 14.0 times, according to FactSet. While the big stocks that dominate the S&P 500 are unusually cheap relative to smaller stocks, the average stock in the broader S&P 1500 index trades at a 10% to 15% premium versus 20-year norms.

Investor sentiment has reached dangerous levels of bullishness, according to two widely followed surveys. Investors Intelligence says 59.6% of investment newsletters are bullish, the highest level since the October 2007 peak of 62.0%. The AAII Investor Sentiment Survey, which measures the percentage of individual investors bullish on the stock market's six-month outlook, puts the percentage of bulls at nearly three-year highs.

We still see opportunities available in individual stocks. The number of truly cheap stocks is below historical norms, and some momentum plays like Netflix ($363; NFLX) have reached stratospheric valuations. But many of the quality growth stocks we favor are still trading at reasonable levels relative to expected growth rates. What's more, our growth-at-a-good-price approach is working nicely, with stocks earning high Overall Quadrix scores outperforming handily over the past six months.

Conclusion

Our buy lists have 93% to 96% in stocks. The market's trend is unequivocally bullish, and we are still finding enough reasonably valued growers to assemble diversified portfolios. Still, we are concerned about the high levels of bullish sentiment, which suggest the risk of a near-term correction is relatively high.

While we are inclined to view a pullback as a buying opportunity, we will be watching how sentiment surveys react to a correction. We'd like to see bullish sentiment drop sharply on a market correction, as it would imply investors have not fully bought into the bull market.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com