Don't Bail Out Yet

8/21/2017


Tensions with North Korea triggered the first volatility in months — and prompted several advisers to call for a more defensive posture. The percentage of bullish investment newsletters has dropped below 51%, down from 60% on Aug. 1, according to Investors Intelligence.

While bears come in many varieties, many of those turning more pessimistic make one or more of the following points:

• Strength in giant stocks masks deterioration in the broad market — a classic symptom of a market top.

• Stocks are outrageously expensive.

• Because investors are unusually complacent, an uptick in volatility could trigger a painful rush to the exits.

From a short-term perspective, the bears’ first point has merit. Still, all bull markets include pauses and pullbacks, and it is hard to argue that the broad market is trending lower. The S&P SmallCap 600 advance-decline line, a running total of daily advancing minus declining stocks, reached new highs on July 25. So did the S&P MidCap 400 advance-decline line.

On the bears’ second point, there is no doubt that U.S. stocks are expensive. But valuations remain well below levels that would suggest we’ve entered a bubble, especially considering today’s low interest rates, modest inflation, and solid profit momentum. Along with improving growth overseas, the weak U.S. dollar should provide a tailwind to earnings over the next year.

The median stock in the broad S&P 1500 Index trades at 19 times expected current-year earnings, about 12% above the norm since 2004. The consumer-discretionary and technology sectors, with the biggest weightings on our buy lists, trade in line with their norms since 2004.

The bears’ third point has considerable merit, though it is impossible to predict the timing of such a downdraft. Market volatility has been unusually low, with the Dow Industrials moving up or down by 1% only five times this year — the fewest for any comparable period since 1965.

As a result, a lot of investors have bet on continued low volatility via exchange-traded funds. On Aug. 10, a day the S&P 500 Index slumped 1.45%, the CBOE Volatility Index surged 44% as traders scrambled to react. With a more substantial, longer-lived pullback, the unwinding of these low-volatility bets could spark a major sell-off.

Conclusion

We worry that many investors are primed to sell at the first sign of trouble, and we’d like to see better price action from small stocks and the Dow Transports. But, with the Dow Theory in the bullish camp, aggressive selling seems premature at this point. Our buy lists have 92% to 95% in stocks.


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