China Worries Keep The Pressure On Stocks

9/7/2015


Amid deepening concerns regarding China and its trading partners, U.S. stocks have slumped. The Dow Theory issued a bear-market signal on Aug. 20, when the Dow Industrials closed below the January low of 17,164.95.

For now, you should maintain a defensive stance. Of the portion of your portfolio committed to equities for the long haul, hold 30% to 32% in a short-term bond fund as a hedge. With the remaining 68% to 70%, emphasize attractively valued growers — and be quick to sell stocks that no longer rank among your favorites.

Two questions

In bear markets, capital preservation is paramount. But history suggests timing the market in an all-or-nothing fashion is a good way to trash your long-term returns, and the Dow Theory cannot forecast the duration or extent of a bear market. So, our stock-market exposure typically ranges from 50% to 100%, based mostly on the answers to two questions:

Q What is the market's primary trend?

A Under the Dow Theory, the Aug. 20 bear-market signal represented confirmation that the majority money opinion is bearish — that the supply of shares exceeds demand, even at levels at which stocks had found support in the past. Broader indexes and unweighted measures like advance-decline lines have confirmed the bearish trend, but no such indicator can tell you how far stocks could fall.

While arbitrary, the convention of defining bear markets as peak-to-trough declines of at least 20% provides some useful historical perspective. For the large-company S&P 500 Index, which does a decent job of tracking aggregate shareholder wealth, the 25 bear markets since 1929 have seen average declines of about 35%, according to Bloomberg. The bear markets ranged from two to 21 months, with an average of 10 months.

The S&P 500 Index, down less than 10% from its May all-time high, would need to drop another 28% to equal the average bear market. While certainly possible, such a decline would leave stocks pretty cheap — assuming the outlooks for corporate profits, inflation, and interest rates don't change materially.

Q Are attractively valued stocks available?

A The median trailing price/earnings ratio for stocks in the S&P 500 is 18, roughly equal to the 20-year norm. Still, stocks are typically cheap at bear-market lows. The median P/E for the S&P 500 bottomed near 10 in 2009 and near 16 in 2000.

At 19, the median P/Es of the S&P MidCap 400 and S&P SmallCap 600 indexes are slightly above 20-year norms. Also, as shown in the table below, these indexes don't look as attractive as the S&P 500 based on the proportion of stocks with modest P/Es. 

HOW MANY STOCKS ARE CHEAP?
--- % Of Stocks With Trailing P/E ---
Below 12
Below 14
Below 16
S&P 500 stocks
Recent percentage
14
24
35
Norm since 12/94
16
26
37
Minimum since 12/94
4
7
14
Maximum since 12/94
60
71
76
% of month-ends lower than recent
52
50
48
S&P MidCap 400 stocks
Recent percentage
12
19
33
Norm since 12/94
14
24
36
Minimum since 12/94
4
10
17
Maximum since 12/94
49
60
67
% of month-ends lower than recent
49
40
44
S&P SmallCap 600 stocks
Recent percentage
10
18
31
Norm since 12/94
16
25
35
Minimum since 12/94
4
9
16
Maximum since 12/94
47
55
61
% of month-ends lower than recent
37
37
43


Conclusion

Stocks are not dramatically overvalued, especially considering today's low inflation rates and bond yields, and we are still finding attractive stocks. But historical precedent and valuations suggest the bear market may have further to go, so our buy lists have an unusually low exposure to stocks.


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