Don't Cash Out Yet

7/21/2014


Helped by a solid start to second-quarter earnings season, the Dow Industrials and Dow Transports edged to fresh all-time highs. But action in the broad market has been choppy, with small and midcap stocks weighed down by valuation concerns. Earnings reports will drive the market averages in the near term, and we would not be surprised by a 5% spurt in either direction.

We are inclined to see any market correction as a buying opportunity, partly because the Dow Theory is in the bullish camp and partly because we still see opportunities among reasonably valued growers. For now, our buy lists have 94% to 97% in stocks.

Reasons to worry

Should you worry that takeover activity has surged to six-year highs, with companies mostly relying on their elevated share prices to pay for the deals? Should you worry that the number of initial public offerings has surged this year, that bullishness among investment newsletters recently reached a multiyear high, and that some richly valued groups like biotechnology and social media are again showing signs of irrational exuberance? Should you worry that average price/earnings ratios for broad indexes like the S&P 1500 are near 20-year highs?

To all those questions, the answer is yes. But worrying and cutting your stock-market exposure are two different things, and we still see reasons to maintain a healthy exposure to equities:

• The primary trend is unambiguously bullish, with both the Dow Industrials and Dow Transports reaching fresh all-time highs in mid-July. While not perfect, the Dow Theory has a good record of keeping investors on the right side of the market.

• Our Quadrix stock-rating system is working nicely. Investors want exposure to profit growth but are wary of paying too much, so we think our growth-at-a-good-price approach will continue to outperform.

• Armed with Quadrix, we are still able to build a diversified portfolio of attractively valued growers. For the 38 stocks on our buy lists, the median for per-share-earnings growth in the most recent quarter is 18%, higher than 62% of U.S.-traded stocks. The median for sales growth in the most recent quarter is 12%, higher than 69% of U.S. stocks. Yet the median P/E on next-year expected earnings, 14, is lower than 67% of U.S. stocks.

Conclusion

The stock market is exhibiting some behavior characteristic of the late stages of a bull market. While that may sound like a reason to sell, history shows that the final stage of a bull market is often the most lucrative time to own stocks. For now, we are maintaining nearly fully invested portfolios while looking for buying and selling opportunities on a stock-by-stock basis.


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