Focus On Stock Selection

1/2/2017


The market's rally has paused, with commentators blaming concerns about rich valuations, lofty profit-growth estimates, and unrealistic expectations of what's likely to get done in Washington.

While a more substantial pullback would not surprise us, we are inclined to view such a dip as a buying opportunity. For now, our Focus List and Buy List have 100% in stocks. Our Long-Term Buy List has 94% in stocks, with the remainder in a short-term bond fund.

Excessive exuberance?

With the S&P 500 Index up 8% and the Russell 2000 Index up 17% since Nov. 4, the market does not need an excuse to pull back. Corrections are part of all bull markets, and stocks have come a long way in a nearly uninterrupted rally since early November.

In fact, a pullback could help prolong this bull market, as it might prevent investor sentiment from becoming too exuberant. As founding Dow Theorist William Hamilton wrote: "One of the safeguards of a bull market is the secondary reaction. It is the most effective check on excessive speculation."

Sentiment surveys suggest both institutional and individual investors are unusually optimistic. Among U.S. consumers, the Conference Board's reading on U.S. consumer confidence rose to a 15-year high in December — despite a dip in the assessment of current economic conditions. While that bodes well for near-term consumer spending, it represents another signal that Americans are vulnerable to disappointment.

Timing secondary corrections with precision is extremely difficult. Our intermediate potential risk indicator, based on the percentage of New York Stock Exchange stocks trading above their 200-day moving averages, is somewhat elevated but not at extreme levels. The current reading is 63% — above the norm of 56% since January 1989, and higher than 56% of weekly observations since 1989.

Conclusion

We intend to keep an eye on our intermediate potential risk indicator, and will not hesitate to sell recommendations that become richly valued. But with the Dow Theory squarely in the bullish camp, the outlook for corporate profits improving, and our growth-at-good-price quantitative approach working again, we don't think this is the time to be raising cash.

Instead, we're focusing on stock selection, avoiding the areas that seem most vulnerable to disappointment. For example, consensus estimates project that the energy and materials sectors will deliver the best earnings growth in 2017. But stocks in both sectors have grown quite expensive relative to historical norms, and our exposure to both groups is limited.


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