Midyear Outlook For Stocks

6/19/2017


After 28 years of midyear outlooks, your editor has learned the secret to avoiding mistakes when making second-half predictions:

Don't make predictions.

While that may sound like a cop-out, I've also learned that you don't need predictions to make money in the stock market. You need to have a view of what's ahead, but relying on one expert's view of the future to allocate your portfolio is a recipe for disaster.

Instead, focus on having a game plan, one amenable to revision if the future does not unfold as planned. Here's what we're watching as we plot our strategy for the second half of this year:

The Dow Theory. When both the Dow Industrials and Dow Transports are reaching significant highs, owning stocks is usually a winning proposition. When both are reaching significant lows, lower stock prices are likely.

The last significant signal under the Dow Theory came on March 1, when both the Industrials and Transports closed at all-time highs to reconfirm the bullish primary trend. Both averages then corrected, but only the Industrials rebounded fully to reach fresh highs.

With a close in the Transports above their March 1 all-time high of 9,593.95, the bullish primary trend would be reconfirmed — and we'd be inclined to lower our cash position slightly.

If the Transports fail to surpass 9,593.95, a breakdown below this spring's lows of 20,404.49 in the Industrials and 8,783.74 in the Transports would be bearish — and a reason to increase our cash position.

The tech wreck and sector rotation. In a bull market, money rotating out of a formerly strong sector will tend to find its way into another part of the market. Encouragingly, when the high-flying technology group slumped on June 9 and June 12, money rotated into banks, energy, and other lagging groups.

Our buy lists have a large exposure to technology, reflecting its market-leading sales and earnings momentum. Also, we're still finding tech names with attractive Quadrix Value scores, partly because of valuations versus historical norms. In fact, relative to the norm since 1994 for average P/E, only consumer-discretionary is cheaper among S&P 1500 sectors.

Still, a 10% to 15% pullback in the tech sector would not be surprising. If it happens, we'll be watching to see if other sectors pick up the slack. We'll also be watching broad market measures like the S&P 1500 advance-decline line. With continued strength in the broad market, we're more likely to maintain our nearly fully invested posture.

Corporate earnings. Stocks are expensive, with the median S&P 500 stock trading at 21 times trailing earnings — 16% above the norm since 1994 and higher than about 90% of month-ends since 1994. Unusually low bond yields and inflation partly explain the rich valuations, but the rebound in corporate earnings growth has also contributed.

Profit-estimate trends for the June quarter have been favorable, partly because of a larger-than-usual number of positive preannouncements from companies. The S&P 500 Index is projected to report year-to-year growth of 6.6% for per-share earnings and 4.9% for sales. As earnings season gets under way in mid-July, we'll be watching the market's reaction to the results.

Bond yields and inflation. As we've said on this page many times, stocks are attractively valued relative to historical norms when compared to bond yields. The Federal Reserve raised short-term interest rates on June 14, its fourth increase since the financial crisis, and indicated it expects one more increase this year. But investors in longer-term bonds don't seem particularly worried about a prolonged rate-hiking campaign, as 10-year Treasury yields hit a new year-to-date closing low after the Fed's statement.

That could change quickly with a jump in wages or inflation. Such a surge seems unlikely in 2017. But the implications of such a surge would be so severe that we intend to keep an eye out for any signs of rising wage growth or inflation pressure.

Conclusion

For now, a nearly fully invested posture remains appropriate. Our buy lists have 92% to 95% in stocks, with the remainder in a short-term bond fund. If market conditions worsen or we cannot find attractive stocks, our cash positions will increase.


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