Defensive Posture Remains Appropriate

9/28/2015


Like a lot of people, we don't like how the stock market is acting. We don't like how it seems to be lurching widely on seemingly minor changes in the consensus outlook. We don't like that industrial and materials shares tied to the global economy have been absolutely hammered, or that richly valued growth stocks have been among this year's best performers.

We also don't like moving wholly into cash, especially when bearish sentiment is running high and reasonably valued stocks are available. For now, as a partial hedge, we're holding 30% to 32% of equity portfolios in a short-term bond fund. With the remainder, we're emphasizing companies with superior operating momentum and below-average valuations.

With breakdowns below the Aug. 25 lows of 15,666.44 in the Dow Industrials and 7,466.97 in the Dow Transports, the bearish primary trend would be reconfirmed and our cash position would likely be increased. If at least one of those lows can hold on the market's next significant decline, we'd be more inclined to lift our equity exposure.

Liquidity worries

Not every stock-market move reflects a change of equal magnitude in the fundamentals. Sometimes, especially when investors are nervous, minor disappointments can seem to trigger major declines. That does not mean the market is irrational, or that such moves will necessarily reverse. It sometimes indicates a “first-out-the-door" effect at play.

When investors worry about the underlying liquidity of assets they own, about whether the price will collapse when selling picks up, they have greater incentive to sell first and ask questions later. When sharp share-price declines triggered trading halts in many stocks on Aug. 24, and prices of many exchange-traded funds (ETFs) dropped well below the underlying value of their assets, experts blamed technical glitches. Still, ETFs failed to provide the liquidity many investors expected, which is likely to encourage some investors to get while the getting is good the next time fear is running high.

A Sept. 22 piece in The Wall Street Journal raised concerns about the liquidity of the bond market, arguing that bond prices could collapse if bond-fund investors rush to the exits. That potential suggests Wall Street's obsession with the timing of the Federal Reserve's first interest-rate is not completely foolish, even if rates only move slightly higher. Nobody knows exactly how bond-fund investors will respond if they suffer a sustained period of negative returns.

VALUATIONS NOT CHEAP BUT NOT EXTREME
Average and median trailing P/E ratios
S&P 500
(Large Stocks)
S&P
-- MidCap 400 --
S&P
SmallCap 600
--- S&P 1500 ---
Average
Median
Average
Median
Average
Median
Average
Median
Recent
20.1
18.0
21.3
18.6
22.7
18.7
21.4
18.5
Norm since 1994
20.8
18.0
21.4
18.1
21.6
18.1
21.2
18.0
% of months lower
than recent since '94
37
47
47
58
65
57
47
55
Breakdown of stocks on trailing P/E
------------------- % Of Stocks with Trailing P/E Of -------------------
0 To 10
10 To 14
14 To 18
18 To 22
Over 22
Or NM
S&P 500 (large cap)
Recent
8
17
23
19
32
Norm since 1994
8
18
22
17
35
S&P MidCap 400
Recent
6
15
24
16
39
Norm since 1994
8
16
22
16
38
S&P SmallCap 600
Recent
6
12
25
14
42
Norm since 1994
9
16
19
15
41

As shown in the top table, the median S&P 500 stock trades at 18 times trailing earnings, in line with the norm since 1994 and higher than about 47% of the month-ends since 1994. Average and median P/E ratios are not as attractive for the smaller stocks in the S&P MidCap 400 and S&P SmallCap 600 indexes, but valuations are not at extreme levels for any of the indexes.

The same trends hold true in the lower table. Based on the number of stocks with trailing P/E ratios below 14, the S&P 500 Index looks best. About 25% of S&P 500 stocks have P/Es below 14, versus about 21% for S&P MidCap 400 stocks and 18% for S&P SmallCap 600 stocks. Stocks in the S&P 500 also compare more favorably to history, with the current P/E breakdown similar to the norms since 1994.

A rush to sell, and a corresponding jump in bond yields, would undermine one of the best arguments of the bulls that stocks are cheap relative to today's low yields. As shown in the the nearby tables, the large stocks in the S&P 500 have price/earnings ratios in line with norms since 1994, while stocks in the S&P MidCap 400 and S&P SmallCap 600 trade at small premiums to historical norms. In other words, stocks are only “cheap" when compared to today's unusually low bond yields.

Conclusion

With bullish sentiment in short supply, a little good news could go a long way toward sparking a rebound rally. But we still think a defensive posture is appropriate, and we intend to wait for confirmation from the averages before returning to a fully invested posture.


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