Under Pressure

2/10/2014


U.S. stocks have extended their pullback on global growth worries, as weaker-than-expected domestic data has exacerbated concerns sparked by signs of a slowdown in China and other emerging markets.

The Dow Industrials have retraced more than 60% of their advance from October lows, while the Dow Transports have retraced more than 40%. Both averages have slumped more than 6% from their recent all-time highs, and there is no doubt that this year's pullback qualifies as a significant correction.

That means the next significant rally will be crucial for Dow Theorists. If both averages surpass their recent highs, the bull market will be reconfirmed. But if one or both fail to reach new closing highs, a breakdown in both averages below the lows established in the current correction would represent a bear-market signal.

Nothing says the averages can't go directly below the October lows without staging a significant rally, and this vulnerability to market crashes is one disadvantage of the Dow Theory. But bear markets, like bull markets, tend not to move in a straight line. Especially after a big bull run, a significant correction is likely to draw bargain-hunters.

Bears argue that any bargain-hunting rally could be a long way off, since U.S. stocks are clearly overvalued and U.S. companies are hardly growing. We disagree on both counts.

As shown in the table below, the median stock in the S&P 500 Index has a trailing earnings yield (earnings/price ratio) of 5.5% — in line with the norm since 1994 and higher than 45% of month-ends since 1994. Small and midsized stocks are more richly valued than the large stocks in the S&P 500, but the median stock in the broad S&P 1500 Index is not outrageously expensive. Relative to bond yields, which have fallen sharply this year, median earnings yields for the both the S&P 500 and S&P 1500 are unusually high.

Earnings have grown more quickly than sales in recent years, pushing corporate profit margins to all-time highs. Stocks could be vulnerable if margins revert to historical norms. But it's a mistake to say companies have become completely dependent on rising margins and share buybacks to sustain growth in per-share profits. As shown in the table below, the median S&P 500 company delivered 6.1% year-to-year revenue growth in its most recently reported quarter — equal to the norm since 1994.

Conclusion

We expect bargain-hunting to key a market rally, and that rally's ability to reach new highs in the Industrials and Transports will determine the status of the Dow Theory. For now, we are looking for buying and selling opportunities on a stock-by-stock basis. Our buy lists have 88% to 92% in stocks.


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