Answering The Tough Questions

7/4/2016


Never let it be said that Dow Theory Forecasts dodges its responsibility to subscribers. Today we provide answers to six thorny questions asked by real readers.

Q Your Focus List doesn't predict winners; just 5 out of the 12 current picks have beaten the S&P 500 Index so far this year. Why should we follow your advice?

A The year 2016 has not been friendly to us. Our Quadrix stock-rating system hasn't performed as well as usual, and several of our individual stock picks have delivered poor returns. Every portfolio has some losers, but this year we'vesaddled readers with more than usual.

So far this year, our Focus List is down 10.2%, while the S&P 500 has gained 1.3%. All that said, we urge you to bear with us, because we've developed an investment approach that has historically proved effective.

If you've seen our long-term returns (visit the Performance section of our website at www.DowTheory.com/Go/Perform), you know our Quadrix system has delivered market-beating results over long periods. In fact, our Buy List and Focus List have outperformed the S&P 500 in five of the last seven full calendar years. While we're proud of that result, we did underperform in two of the last seven, and lag so far this year as well.

We have faith in our investment approach because it works. No system beats the market all the time, but our history suggests we win more often than we lose. Plus, Quadrix tends to come back strong after periods of weakness.

It's your money, and of course you can invest it however you like. But we hope you'll stick with us for a while longer.

Q Since I started subscribing to the Forecasts, you haven't recommended an equity weighting below 70%. How does this help subscribers, particularly those old enough so a 70% stock weighting is too high even at the market's most bullish?

A You're correct about our equity position rarely going below 70%. But please be aware that we're not advocating a 70% equity position for a fully diversified portfolio. No single stock/bond allocation works for every investor, and our recommended equity position applies only to the portion of your portfolio allocated to stocks for the long haul.

For example, suppose you have $1 million, and based on your age and financial position, you desire a 50% equity, 50% fixed income allocation. Our newsletter focuses chiefly on the half of that portfolio allocated to equities. We currently recommend a stock position of 83.5% for our Buy List, which means 41.8% of your total portolio, or $417,500, should be in stocks. The remaining $582,500 should be in bonds.

While our target allocation has nothing to do with your fixed-income holdings, we do recommend several bond mutual funds to provide the fixed-income exposure you need (www.DowTheory.com/Go/Fund).

Historically, our cash/fund position has enhanced returns. Since the inception of the Focus List in 1994, it has returned 507% excluding dividends and transaction costs, well above the S&P 500's 350% return. However, we began providing a cash/bond position in 1998. Taking those positions into account, the Focus List has returned 565% since inception. Just as importantly, the annual returns including cash or bonds were less volatile than those of the fully invested Focus List and roughly the same volatility as the returns of the S&P 500, which of course contains a lot more stocks.

Q Can you explain the stock and bond split in your conservative mutual fund portfolio? It seems high for a conservative approach.

A Our Conservative Portfolio has about 28% in bonds and cash, which is a fairly cautious weighting for most people in asset-building mode. In contrast, our Growth Portfolio has 19% in bonds and cash. For more on these portfolios read the June 20 issue (www.DowTheory.com/Go/June20).

The word "conservative" means different things to different people. We focus on equities rather than bonds, and most of our subscribers, even those in or nearing retirement, remain interested in accumulating wealth. Those investors more concerned with preserving assets may want to adjust the percentages to boost bond ownership. However, history shows that over time, stocks tend to beat bonds. All but the most conservative of investors should probably own at least some stocks.

Q Why do you keep recommending Alaska Air Group ($58; ALK), CBRE ($27; CBG), and Skyworks Solutions ($62; SWKS)? They may have been good stocks once, but they've stunk recently. Shouldn't timing be as important as quality?

A Timing is important, certainly. But we still value quality more. The stocks mentioned in the question above have performed poorly, yet remain operationally solid.

• CBRE has been a huge disappointment this year, though the weakness and the days following Britain's exit from the European Union seems overdone. The global real-estate market enjoys solid demand and en-couraging price trends. We've made a conscious decision to stick with CBRE despite the weakness, albeit on a shorter leash than in the past. The stock has outperformed analyst profit expectations in nine of the last 10 quarters, .

• Airlines have delivered poor returns this year. However, Alaska Air has returned more than 45% since we first recommended it in February 2014. Recent weakness has left Alaska, and the entire airline industry, looking cheap. Alaska's pending purchase of Virgin America ($56; VA) may have put added pressure on the shares. We see a lot to like in the combination, though the price was somewhat
steep. Alaska must deal with questions about how it will integrate the quirky airline.

• Most of Skyworks' suffering stems from weakness at its largest customer, Apple ($94; AAPL), which in the March quarter posted its first year-over-year decline in iPhone sales. Even if Apple's CEO was wrong when he called the decline a "pause in growth," Skyworks sells to many other high-growth markets, while the "internet of things" is moving from dream to reality. The consensus projects per-share-profit growth of 4% in fiscal 2016 ending September, then faster expansion after that.

Of course we'd prefer that none of our stocks ever lost value. But sometimes they will, because nobody gets them all right. If a stock's price decline seems overly punitive and we believe the company can generate enough good news to turn the tide, we'll often choose to stick with it — particularly if its Quadrix scores remain strong. CBRE earns an Overall score of 84, while Alaska scores 90 and Skyworks 90.

Q I like the idea of ranking stockswith a single number to compare their investment appeal, but how do your Quadrix scores take into account broad issues like the threat of the Zika virus or terrorist attacks?

A The short answer is that Quadrix doesn't reflect the macro issues you mention because it cannot factor in such risks. That inherent limitation of quantitative models explains why we don't simply buy all the top-rated stocks.

From a broader analysis perspective, however, Quadrix's inability to assess qualitative factors isn't that big a problem. Threats such as Zika and terrorist attacks could potentially hurt the market by affecting investor sentiment or, less likely, corporate profits. But, with some exceptions, these negative pressures would affect the market as a whole rather than targeting individual stocks.

Since we deal with rough markets by raising our recommended cash or fund position rather than bailing out of stocks en masse, Quadrix doesn't have to address those issues to serve our purpose. We never get entirely out of equities, nor do we stop seeking superior stocks for investment, even during bear markets.

Of course, some external factors affect specific stocks or industries more than others. Examples include regulatory changes, inclement weather, or a recession in a foreign country with a major presence in a specific business. In such cases, we start with Quadrix, then augment with individual company analysis, a strategy that has worked for us for more than 16 years.

Q You've written that some of your Quadrix category scores work better than others. Why not scrap the weaker ones?

A The Overall score works because it considers so many categories, some of which have little value on their own. Our Financial Strength score doesn't have much predictive power in most sectors. But when we tested Quadrix without the contribution of Financial Strength, the Overall score lost some of its power.

This broad approach allows Quadrix to reflect many facets of the market, and thus limit the damage that can occur when one category of statistics falls out of favor.


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