All Trading Ranges End

9/12/2016


After nearly eight weeks of sideways trading, with daily volatility near historic lows, you might think that stocks are drifting aimlessly — and that worrying about fundamentals is a waste of time.

Don't make that mistake. You should always worry about the health of the stock market — and always question what passes for conventional wisdom. Here's our take on five key themes likely to figure in the market's eventual breakout or breakdown.

Stocks are expensive, but not as ridiculously overvalued as some bears argue. Based on both average and median trailing price/earnings ratios, stocks in the S&P 500 Index trade at a 7% to 13% premium compared to norms since 1994. The same applies for the S&P Midcap 400 and S&P SmallCap 600 indexes. About 17% of stocks in the broad S&P 1500 Index have P/Es below 14, versus the norm of 24% since 1994.

Corporate earnings growth is weak, but most companies are still growing sales and earnings. Over the past 12 months, the median S&P 1500 company delivered growth of 3.5% for sales, meaning one-half of companies reported growth of at least 3.5%. Median growth in per-share earnings was 4%. In their most recent quarter, S&P 1500 members reported median growth rates of 5.6% for per-share earnings and 4.5% for sales, versus respective norms of 8.7% and 5.9% since 1994.

Stock-market leadership will hinge on interest rates and the pace of profit growth. While the major averages have moved sideways since July, beneath the surface investors have rotated into companies expected to benefit from faster economic growth and higher interest rates. That rotation has partly reversed over the last week because of some disappointing economic reports, helping the bond-like utility and telecom sectors that led in the first half of this year.

The election matters. For better or worse, Wall Street sees Hillary Clinton as the safe choice, and the favorite to win. Forecasting services like FiveThirtyEight, CNN, and Predictwise give Clinton about a 70% chance of victory. Wall Street is also betting that Republicans will retain at least one house of Congress, extending the divided government many investors prefer. A lot could change by election day on Nov. 8, but a Trump victory or Democratic sweep of Congress could trigger volatility.

The broad market has been moving higher, and the Dow Transports have rallied within 1% of the April high of 8,109.19.  As shown by the S&P 1500 advance-decline line, a running daily total of advancing minus declining stocks, most stocks are rising. A close above 8,109.19 in the Transports would put the Dow Theory in the bullish camp, and trigger an increase in our stock-market exposure. For now, reflecting this week's addition of Zions Bancorp ($31; ZION), our buy lists have 83% to 84% in stocks.


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