The road ahead

10/20/2008


Among human emotions, regret is among the least productive — at least when it comes to investing.

Like most, we regret not raising more cash ahead of the market’s meltdown. We regret not taking profits in the oil stocks this summer, or cutting bait on Oshkosh ($8; NYSE: OSK) sooner.

But feeling regret doesn’t pay the bills, and the worst thing you can do is lose perspective on today’s market because you’re anchored in the past. Whether you could have sold a stock higher three months ago is irrelevant; what matters is whether you think it is headed higher from here.

The same holds true for your cash position. Don’t let the extreme volatility of recent months paralyze you into inaction. Whether or not you make any changes to your portfolio, you’re making a decision. Every trading day you wake up with an opportunity to cash in all or some of your chips. To the extent you make that decision consciously — free of regret and unclouded by panic — you’re likely to be better off over the long haul.

For our money, holding about 30% of equity portfolios in a short-term bond fund represents a good trade-off between respecting the market’s bearish trend and maintaining exposure to attractively valued stocks. In fact, if you lifted your cash position to 30% on Sept. 30, the day after the Dow Transports confirmed the bearish
primary trend, you may need to do some buying to get your stock exposure back to 70%.

Below, we highlight three key themes for the year ahead.

The price movement. Rarely does a one-day rally have much importance. But when the Dow Industrials surge 11% in a single session — one day after option prices and other measures indicated fear was near all-time highs — the rally takes on some significance. The Dow Transports have already given back all their Oct. 13 gain, while the Dow Industrials now trade about 1.5% above the Oct. 10 closing low of 8,451.19.

A breakdown below the Oct. 10 lows would suggest concerns regarding the economy have not been fully discounted. Investors are worried that the global economy faces serious headwinds — even if government bailouts restore some normalcy to the credit markets.

If the Industrials can hold above 8,451.19 in the near term, a rally to 10,000 to 11,500 would not be surprising. The Industrials dropped about 4,600 points from the May high to the October low, and a typical bear-market rally retraces one-third to two-thirds of the previous decline. Such a rally may represent an opportunity to raise more cash.

The profit outlook. Because of government intervention, the risk of a complete breakdown in the capital markets has diminished. But investors are now grappling with the prospect of a global recession. Profit forecasts for 2009 do not reflect this prospect, as consensus estimates still forecast growth for most sectors.

While estimates are likely to come down across the board, consumer-related companies seem particularly vulnerable. With wages growing slowly, credit extremely tight, and home prices falling, many U.S. consumers are hitting a wall.

Profit estimates for materials and energy companies are also likely to drop, though current valuations suggest such estimate cuts are already reflected in stock prices. Select technology areas could hold up better than in past downturns; in the main, nonfinancial corporations have solid balance sheets and strong incentives to boost efficiency.

Valuations. The one positive in today’s environment: Stocks are cheap, even assuming the U.S. has entered a recession. Among 24 stocks on our Buy List, 18 trade at less than 10 times expected next-year earnings — even though consensus estimates still predict
profit gains next year for all 24 Buys except Chevron ($69; NYSE: CVX).

  SECTOR SNAPSHOT
Based on consensus estimates, the S&P 500 Index trades at roughly 10 times expected 2009 earnings. All sectors of the S&P 500 trade at a discount relative to the average forward P/Es since 1995.
2007
—— Actual ——
2008
— Estimates —
2009
— Estimates —
Profit
Change
(%)
P/E
Ratio
Profit
Change
(%)
P/E
Ratio
Profit
Change
(%)
P/E
Ratio
Avg. Yr.-
Ahead P/E Since
1995
S&P 500 Index
(6)
18
(7)
13
35
10
15
Consumer Discretionary
(16)
20
(28)
19
59
12
19
Consumer Staples
10
19
10
15
13
14
19
Energy 
6
13
23
7
13
6
16
Financials 
(39)
17
(79)
45
449
8
13
Health Care
16
18
10
13
14
11
21
Industrials
12
17
4
10
7
10
17
Information Technology 
15
24
12
14
22
11
25
Materials
5
16
7
10
11
9
16
Telecom Services 
4
20
16
11
17
9
18
Utilities 
2
19
9
12
12
10
14
Source: Standard & Poor’s, based on analysts’ estimates for operating earnings.

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