Our Game Plan For 2015

12/15/2014


The Dow Jones Industrial Average will finish 2015 at 19,311, unless corporate earnings, interest rates, inflation, or other crucial variables differ from our expectations. Also, if investors become more or less optimistic regarding the future, or more or less willing to hold volatile assets like stocks, our target may be off. 

The purpose of this worthless forecast is rhetorical, for this is the time of year to keep two things in mind regarding expert predictions:

They are not very good. A large and growing body of academic research suggests expert predictors in such fields as economics, finance, and political science do no better than dart-throwing chimps. What's worse, prominent pundits tend to be overconfident, even when things don't unfold as they anticipated. Especially in the stock market, wrong and headstrong is a dangerous combination.

They are not very useful. Let's say you have above-average ability to predict the Dow's year-ahead level — not Amazing Kreskin ability but better than 90% of forecasters. Given how bad the typical prediction is and how often the crowd is completely wrong, are you really going to set your investment policy based on a prediction you made in December, even as unexpected reports on corporate earnings, interest rates, and inflation are released? You won't if your goal is to make money; you might if you invest to prove how smart you are.

Our advice

You don't need amazing foresight to be a good investor. What you need is a game plan, a disciplined yet reactive strategy that helps keep the odds in your favor. Here are the variables we'll be watching in 2015:

The Dow Theory. When something major changes in the financial markets, don't focus on what the experts think of the change. Listen to what the averages say.

For example, the Dow Industrials reached all-time closing highs after oil prices collapsed on OPEC's Nov. 27 decision to maintain its current output. In contrast, the Dow Transports have yet to close above their Nov. 25 all-time high of 9,202.84, even though fuel costs are a major expense for nearly all 20 members of the index.

Despite recent pullbacks, both the Industrials and Transports are within 4% of new closing highs, and the Dow Theory is squarely in the bullish camp. But we'll be watching to see if the Transports can confirm the new highs in the Industrials.

Investor sentiment. Both bear markets and bull-market corrections tend to start when bullish sentiment is high, like it is now. Sentiment tends to be extremely bullish at the end of a major bull market, but distinguishing between bullish and extremely bullish can be tough when stocks are rising.

When stocks retreat, bullishness tends to recede quickly in a bull-market correction, since many investors are not yet fully convinced the bull has staying power. At the end of a bull market, bullishness is slower to recede because nearly everybody is convinced the outlook is sunny.

Since late 2010, every market pullback has triggered a sharp drop in bullish sentiment among investment newsletters. We'll be worried if that does not happen in the next correction, especially if other indicators also reveal stubborn optimism.

Valuations. At the end of a bull market, stocks tend to be quite richly valued. Today stocks are expensive but not egregiously so, at least relative to trailing 12-month earnings. The S&P 500 Index's trailing price/earnings ratio is between 19 and 20, slightly above the 50-year norm of 19. The median S&P 500 stock trades at a 9% premium to the 20-year norm.

The opportunities available in individual stocks. While cheap stocks are scarce, we are finding enough reasonably valued names for our growth-at-a-good-price approach. About 41% of S&P 500 stocks have trailing P/Es of less than 18, below the 20-year norm of 48%. More important, our approach is working, with Overall Quadrix® leaders and our buy lists delivering strong returns.

Conclusion

With stocks expensive and investor sentiment bullish, this is no time for complacency. But the weight of the evidence still favors higher stock prices, and we are maintaining a nearly fully invested posture. Our buy lists have 91.9% to 97.2% in stocks.


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