Global Worries Sink Stocks

10/20/2014


U.S. stocks have slumped broadly and sharply, with fears of an Ebola epidemic compounding worries regarding a global economic slowdown. Reflecting several downgrades, our cash position has increased to 12.5% for the Focus List and Buy List and 13.2% for the Long-Term Buy List.

In periods of market turmoil, when keeping a level head can be tough, we find it helpful to focus on the four core drivers of our stock-market exposure.

The primary trend. Both the Dow Industrials and Dow Transports closed at all-time highs in mid-September. The primary trend will be regarded as bullish under the Dow Theory until proved otherwise, and the recent decline is consistent with a correction in a bull market. With rebounds above the September highs of 17,279.74 in the Industrials and 8,676.19 in the Transports, the bullish trend would be reconfirmed. For a bear-market signal, two things must happen. First, the averages need to rebound meaningfully without both reaching new highs. Second, both need to close below the lows established in the current correction.

Valuations. Partly because consensus estimates call for record earnings in the year ahead, the S&P 500 Index's forward price/earnings has dropped to 14 — in line with its 10-year norm. Based on trailing price/earnings ratio, the median stock in the S&P 500 trades in line with the 10-year norm and at a 4% discount to the 20-year norm. Relative to bond yields, earnings/price ratios on stocks are very attractive versus historical norms.

Investor sentiment. Surveys suggest sentiment has shifted considerably, though not to the extreme levels that often signal market bottoms. According to Investors Intelligence, the percentage of bullish investment newsletters is below 38%, down from more than 57% on Sept. 9. But the percentage of outright bears is still below the levels reached in April. Based on net exposure in S&P 500 futures contracts, Goldman Sachs says traders have seldom been more pessimistic. But bullishness among Wall Street strategists remains near five-month highs.

The opportunities available in individual stocks. While we had expected to use a market pullback as a buying opportunity, for now we are holding on to some extra cash. The stocks we are most interested in adding to our buy lists are under heavy selling pressure, while most of those showing strength do not look particularly attractive. As third-quarter earnings are reported, we will be looking for attractively valued shares able to bounce on better-than-expected results. And we will be quick to sell stocks that no longer rank among our favorites. Among our current recommendations, Alaska Air Group ($42; ALK) and Ameriprise Financial ($109; AMP) represent top rebound plays.


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