Our Cash Position Explained

3/9/2009


 

As a defensive hedge, our Focus List and Buy List have 37.9% in Vanguard Short-Term Investment-Grade ($9.74; VFSTX), while our Long-Term Buy List has 36.2% in this relatively low-risk bond fund. These percentages hinge on three questions:

What is the market’s primary trend? When both the Dow Industrials and Dow Transports are reaching significant lows, as both did this month, the primary trend is presumed bearish under the Dow Theory.

Where do we stand in the market cycle? The Dow Theory tells you the market’s trend; it does not tell you how long that trend is likely to endure. History provides an imprecise guide. The Industrials have dropped 53% from their record close of 14,164.53 on Oct. 9, 2007, making this the second-worst U.S. bear market. But, at 17 months, this bear market has lasted only slightly longer than the average bear market since 1899.

Sentiment and valuation provide perspective on the market cycle. As described in the main article on page 1, pessimism among newsletter editors and consumers is near all-time highs — historically a signal that a bear market may be nearing its end.

The valuation picture is not quite so clear. Reflecting sharply lower corporate profits, the trailing price/earnings ratio of the S&P 500 Index is above 25, well above its historical average of 15. But S&P 500 earnings are being weighed down by huge losses at a relatively small number of companies. The median profitable company in the S&P 500 trades at less than 11 times trailing earnings, versus the norm of 18 since 1990.

Using 10-year average earnings, the S&P 500 Index’s P/E is about 12, versus about 16 over the past century.

What opportunities are available in individual stocks? The S&P 500 Index comprises about three-fourths of the U.S. stock market’s total value, so examining whether this index is expensive or cheap is a worthwhile exercise. More important, however, is the number of attractively valued stocks available. Among S&P 500 stocks, the number of profitable companies with P/E ratios below 10 has surged to 230, versus an average of 41 since 1990.

Since 1990, S&P 500 stocks with P/Es below 10 have delivered an average year-ahead return of 17.3%. In contrast, returns have averaged 13.4% for those with P/Es of 10 to 12, 12.8% for those between 12 and 14, and 10.7% for those between 14 and 75.

Conclusion
The primary trend is bearish, and the weight of the evidence suggests lower stock prices are probable. But sentiment and valuation numbers suggest much of the damage has been done, and plenty of bargain-priced stocks are available. An especially attractive value is Oceaneering International ($29; OII).


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