Mostly Bearish, But Interested
As always, our recommended equity exposure depends on our assessment of the primary trend, the market's valuation, investor sentiment, and the opportunities in individual stocks. Here's how we see things now:
• The Dow Theory. Before a recent dip, the Dow Industrials had retraced 87% of the November-to-February decline, while the Dow Transports had retraced the same percentage of their November-to-January decline. Those are bigger-than-normal retracements for a bear-market rally, but both averages will need to surpass significant highs for a bull-market signal.
Closes in the averages below this year's lows of 15,660.18 in the Industrials and 6,625.53 in the Transports would confirm the bearish trend. If the averages correct but one or both averages hold above those lows, rebounds above the highs established in the recent rally would return the Dow Theory to the bullish camp.
Both averages are within 3% of the highs reached in November, and moves above those levels would muddy the picture under the Dow Theory. But surpassing the November highs would not represent an all-clear signal, in our view, as the Transports are still roughly 14% from all-time highs.
• Market valuation. Based on trailing and expected current-year price/earnings ratios, the median S&P 500 stock trades at a slight premium to long-term norms. P/Es are unusually low in relation to bond yields, but profit growth is also unusually low.
• Investor sentiment. Among investment newsletters, the percentage of bulls has jumped to a six-month high of 47.4%, surpassing the peak reached in November, according to Investors Intelligence. Among individuals surveyed by the American Association of Individual Investors, bullishness has rebounded to five-month highs, though it remains slightly below long-term norms.
• The opportunities in individual stocks. Among stocks on our Buy List that reported December-quarter results, the median company reported year-to-year growth of 21% for per-share profits and 8% for sales. That compares to respective medians of 1% and 2% for all S&P 500 companies in their most recent quarter. Yet the median stock on our Buy List trades at 23% discount to the median S&P 500 stock based on current-year P/E ratio.
While the averages have rebounded impressively, the weight of the evidence suggests the Dow Theory remains in the bearish camp. Valuations and investor sentiment are middling, but we still find opportunities among reasonably valued growers. For now, our buy lists have 81% to 82% in stocks, with the remainder in a short-term bond fund.