Primary Trend Bearish

8/31/2015


At times of market turmoil, a focus on core principles can help. For our money, that means taking defensive measures when the averages render a bearish verdict on the market's primary trend. But we're not going to abandon stocks altogether, and we're not going to stop looking for attractively valued growers.

With this week's downgrades, our buy lists have 68% to 70% in stocks, with the rest in a short-term bond fund. As always, our stock-market exposure will change as our core market-timing indicators change.

The primary trend. With both the Dow Industrials and Dow Transports reaching their lowest levels in more than a year, the Dow Theory is unequivocally in the bearish camp. Broader, capitalization-weighted measures like the S&P 500 and Wilshire 5000 indexes also reached significant lows, as did unweighted indicators like the S&P 1500 advance-decline line.

For a return to the bullish camp, three things must happen. First, both the Industrials and Transports need to stage significant rallies. Second, in the subsequent declines, one or both averages need to hold above the lows reached prior to the significant rallies. Third, both averages need to close above the highs reached in the significant rallies.

Valuations. Partly because a lot needs to happen for a bull-market signal under the Dow Theory, we're also going to be looking for signs that stocks have become cheap. If we can find bargains, we'll be more inclined to increase our stock-market exposure in advance of a bull-market signal.

Down about 10% since mid-August, the average stock in the S&P 500 now trades at roughly 19 times trailing earnings — about 7% below its norm since 1994. That is not the kind of rock-bottom valuation often seen at bear-market bottoms; the average trailing P/E reached 11 at the March 2009 low. But stocks remain quite cheap relative to yields on high-quality bonds.

Sentiment. When nearly everybody is convinced stocks are headed lower, they have a habit of defying expectations — at least in the short run. While such sentiment-driven rebounds may represent either mere bear-market rallies or the first stage of a new bull market, they are worth considering as you plot strategy.

Mutual-fund outflows and surveys suggest U.S. individual investors are quite bearish but not yet despondent. Hedge funds are as bearish as they have been in several years, and the percentage of bullish investment newsletters is at five-year lows.

Conclusion

At 68% to 70%, the stock-market exposure of our buy lists is quite low versus historical norms. We are unlikely to ever dip below 50%, but we may consider lowering our stock exposure below the current range if the market stages a sharp rally.


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