Caution Warranted

5/2/2016


Stocks have been choppy, with the Dow Industrials and S&P 500 Index unable to move past all-time highs despite the Federal Reserve's assurances that it will proceed cautiously in raising interest rates. For now, as a partial hedge, our buy lists have about 22% in a short-term bond fund.

Eroding estimates

More than 200 members of the S&P 500 Index have reported first-quarter results, with about 75% exceeding consensus estimates for per-share earnings. But per-share earnings for the index are now expected to be down more than 9%, with seven of the index's 10 sectors reporting declines. Revenue is expected to be down 1%, with five sectors posting lower sales, according to FactSet.

Year-ahead profit estimates continue to erode, and both earnings and sales are expected to decline again in the June quarter. But the consensus still calls for a turnaround in the second half of the year, with per-share profits up 3% in the third quarter and 8% in the fourth quarter.

While those projections are widely doubted, the S&P 500 Index trades at 16.8 times expected year-ahead earnings — well above the 10-year norm of 14.2. Nine of the 10 S&P 500 sectors trade at a premium to their 10-year norm.

Fortunately, we're not limited to the capitalization-weighted S&P 500 Index for our stock-market exposure. We still believe a diversified portfolio of attractively valued growers — like the stocks on our buy lists — will outperform the S&P 500, bonds, and cash over the next five and 10 years.

But the typical U.S. stock also trades at a premium to long-term norms, and we're skeptical the broad market can maintain its momentum without a better outlook for corporate earnings. Defensive areas like consumer staples and utilities have seldom become more expensive, so the outlook for more cyclical groups like consumer discretionary, financials, industrials, and technology is crucial.

Conclusion

Investors know that valuations are somewhat expensive and earnings are declining, yet the broad market has advanced steadily since February, with cyclical areas showing much-improved relative strength.

Is the broad market discounting an upturn in the global economy and a rebound in earnings growth? Or did investors simply get too pessimistic earlier this year, leading to a bear-market bounce? Time will tell, but we probably won't return to a fully invested posture without a better earnings outlook and a clear bull-market signal under the Dow Theory.


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