Keep Your Powder Dry

2/1/2016


U.S. stocks have stabilized, helped by a bounce in oil prices. But trading remains choppy, and we would not be surprised to see another leg down in the averages. For now, as a partial hedge, our equity portfolios have 21% to 24% in a short-term bond fund. Some related points:

The Dow Theory is squarely in the bearish camp. A breakdown in the Dow Industrials below the August closing low of 15,666.44 would be discouraging. But both the Dow Industrials and Dow Transports have already broken through significant support levels.

So far, December-quarter earnings have mostly failed to impress. While the percentage of companies exceeding consensus profit expectations tops the level of recent quarters, relatively few stocks have rallied meaningfully on the results.

Investor sentiment is unusually bearish. Based on mutual-fund cash levels and surveys of individuals, newsletters, and Wall Street strategists, bullishness is in short supply. With sentiment so depressed, a little good news could trigger a major bounce in the market.

The number of attractively priced stocks has jumped. As shown in the table below, about 33% of S&P 500 stocks have trailing price/earnings ratios below 14, above the norm of 26% since 1994.

More stocks trading at modest P/E ratios
--------- % Of Stocks With Trailing Price/Earnings Ratio Of ---------
0 To 10
10 To 14
14 To 18
18 To 22
Over 22
Or NM
S&P 500 Index (large-cap)
Recent
13
20
21
19
27
Norm since 12/94
8
18
22
17
35
S&P MidCap 400 Index
Recent
10
24
21
15
30
Norm since 12/94
8
16
22
16
38
S&P SmallCap 600 Index
Recent
11
17
20
15
37
Norm since 12/94
9
16
19
15
41
S&P 1500 Index
Recent
11
20
21
17
32
Norm since 12/94
8
17
21
16
38

Term spreads don't yet point to recession. When the spread between yields on l0-year and two-year Treasury bonds shrinks dramatically, it tends to signal that investors worry about an imminent recession. While the spread has narrowed recently, as shown in the the linked chart, it remains in line with 20- and 30-year norms.

Widening credit spreads are a concern. Yields on junk bonds have soared, partly because of expectations of widespread defaults from energy producers. Even more worrisome, default concerns are also impacting investment-grade bonds. Yields on Baa-rated corporate bonds (at the low end of investment grade) have widened relative to Treasury bonds and Aaa corporate bonds.


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