Uncertainty reigns

11/24/2008


In periods of great uncertainty, sometimes it’s good to step back and take stock of what you do know. Here are three conclusions in which we have a high degree of confidence:

The market’s primary trend is down. The Dow Industrials, Dow Transports, and S&P 500 Index have moved to fresh multiyear lows, as have equal-weighted measures of the broad market. The financial sector, which has led the market lower over the past year, is again leading to the downside.

Holding some cash in reserve is prudent. First, based on your age, return objectives, and risk tolerance, decide how much of your money you want committed to equities for the long haul. This percentage should depend on your return expectations for stocks, bonds, and other assets over the next 20 or 50 years — not on today’s gloomy environment.

Second, of the portion you are allocating to equities for the long haul, keep 25% to 35% in cash as a partial hedge. We’re holding 29.8% of our Focus List and Buy List and 34% of our Long-Term Buy List in Vanguard Short-Term Investment-Grade ($9.72; VFSTX). In our view, the fund’s yield of 6.1% is adequate compensation for taking on a little credit risk with our short-term reserves.

Stocks are cheap relative to trailing 12-month earnings, but investors are worried about a sharp decline in corporate profits. Excluding price/earnings ratios above 75 or below 0, the median stock in the S&P 1500 Index of large, midcap, and small stocks trades at about 12 times trailing earnings — the lowest since the Index’s 1994 inception and well below the 14-year norm of 18.

Using average 10-year trailing earnings, the S&P 500 Index’s P/E is below 14. Yale economist Robert Shiller says the average for this measure was 14.6 from 1890 to the early 1990s, after which P/Es moved sharply higher.

Clearly, investors are bracing for a downturn in corporate profits. So far, average per-share earnings growth has remained positive for S&P 1500 companies, as shown below. But our calculated average is skewed by the exclusion of companies with 12-month profit declines of more than 75%, and investors are worried that the huge declines seen in financials will be repeated in other sectors.

In such an environment, attractively valued shares of companies positioned to meet expectations and post solid earnings growth seem like a relatively good bet. Top picks include Accenture ($29; NYSE: ACN), Biogen Idec ($44; NASDAQ: BIIB), Harris ($31; NYSE: HRS), and St. Jude Medical ($31; NYSE: STJ).


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