What to do

12/15/2008


Making year-end forecasts is dicey in the most tranquil times, so some practical and prediction-free recommendations are especially appropriate today. Here, in four parts, is our portfolio advice for the year ahead:

Hold some short-term reserves. As a partial hedge, hold 25% to 35% of your equity portfolio in a money-market or short-term bond fund. While Vanguard Short-Term Investment-Grade ($9.59; VFSTX) has lost 5.8% this year, the fund now yields about 6% and seems likely to outperform money-market funds in 2009.

Watch the averages. As always, our recommended cash position will depend on the Dow Theory and the opportunities available in individual stocks. For a return to the bullish camp under the Dow Theory, both the Dow Industrials and Dow Transports will need to reach significant highs. So far, significant highs have not been established, though the levels reached in the current rally could qualify with moves to about 9,375 on the Industrials and 3,820 on the Transports. A move back down below the respective Nov. 20 closing lows of 7,552.29 and 2,988.99 would be discouraging.

Watch the reaction to news. Encouragingly, the market has advanced since Nov. 20 amid bleak economic news, with several beaten-down stocks rallying despite profit warnings. Especially if the recent bounce is extended, the market’s resiliency will be tested as earnings season approaches. Many see consensus forecasts of higher S&P 500 earnings in 2009 as wildly optimistic, but this bearish argument will lose potency if stocks advance amid a flurry of profit warnings.

Keep your money in your best ideas. Nobody likes to sell a stock down sharply from the purchase price. But your decision to keep or sell a stock should depend on its prospects going forward — not on whether you can avoid taking a loss. With the median U.S. stock down more than 50% over the past 12 months, there is no shortage of rebound picks. So, you might as well own the best ones available — even if it requires dumping less-attractive names with decent potential. With that in mind, we’re replacing Adobe Systems ($23; NASDAQ: ADBE) with Cognizant Technology Solutions ($18; NASDAQ: CTSH).

Adobe has rallied modestly since Dec. 3, when the software concern issued disappointing guidance. The company expects November-quarter earnings in line with Wall Street estimates. But revenue is expected to be below earlier guidance, and sales and profit guidance for the February quarter disappointed. Adobe’s Quadrix® Overall score has dropped to 80, down from 97 in July. The score should drop further because of profit-estimate cuts and unfavorable near-term profit comparisons. At less than 13 times expected year-ahead earnings, the stock is cheap versus historical norms. But Adobe is not cheap relative to the software group, and we would not be surprised by another profit warning. Adobe, which is being downgraded to Neutral, should be sold.

Shares of Cognizant, a provider of outsourced technology services with an outstanding long-term track record, have been hurt by concerns that companies will cut tech budgets for 2009. But Cognizant says demand from new clients remains strong, and profit estimates for 2008 and 2009 have held up relatively well. Free cash flow has shown solid growth in recent quarters, while Cognizant’s debt-free balance sheet has about $2 per share in cash. At 11 times expected year-ahead earnings, the stock trades at its cheapest valuation in more than 10 years. While a return to the five-year average forward P/E of 28 seems unlikely, Cognizant seems capable of a rebound to $24 over the next year. Cognizant, with an Overall Quadrix score of 95, is replacing Adobe on our Buy List and Long-Term Buy List.


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