Your Questions Answered

5/25/2009


After nearly 20 years of writing for Dow Theory Forecasts, I’ve learned to answer a question or two from those who pay the bills. I’ve also learned to make up a question to illustrate a point. This column aims to showcase both skills.

Q I don’t understand your asset-allocation advice. Your advertising says the Dow Theory is the best thing since sliced bread, and your Market Commentary says the Dow Theory is in the bearish camp. So, why aren’t you 100% in cash?
A First, I don’t think using the Dow Theory in an all-or-nothing fashion makes sense. Doing so puts a huge premium on timing the market precisely, something few investors have shown the ability to do consistently. Rather than staking subscribers’ long-term wealth entirely on our ability to zig in and out of the market, we use the Dow Theory in an incremental fashion, with our recommended cash position typically ranging from 50% to 0%. The way I see things, holding 30% to 40% of an equity portfolio in short-term bonds is a big wager, one likely to detract considerably from long-term returns unless we add value with our interpretation of the Dow Theory.

Second, the Dow Theory is best viewed as a system, not a forecasting device. More than 100 years of market history suggest investors generally do well owning stocks when both the Dow Industrials and Dow Transports are reaching significant highs — and avoiding stocks when both are reaching significant lows. But the Dow Theory cannot predict the duration or extent of market moves, nor can it tell you the market’s direction with absolute certainty.

Third, the recent action of the averages suggests a middle-of-the-road approach is appropriate. The Dow Theory is clearly in the bearish camp, as the last confirmed signal was the move to new lows in both averages in March. But that does not preclude the possibility that the bear market ended in March. If the rally since March represents the first stage of a new bull market, at least one of the averages will hold above the March lows when the market corrects, then both averages will rebound above the highs established in the current rally. If the bear market remains in force, the averages will move below the March lows.

Fourth, our asset-allocation advice depends on both the Dow Theory and the opportunities available in individual stocks. The market’s primary trend is crucial, and the valuations of the S&P 500 Index and the typical stock are worth knowing. But more important is our ability to find attractively valued stocks. To the extent we can find high-potential stocks that fit in a diversified portfolio, we’ll be more inclined to reduce our cash position. For now, we’re keeping 31% to 33% of our recommended equity portfolios in Vanguard Short-Term Investment-Grade ($10.08; VFSTX), a relatively low-risk bond fund.

Q How can you add a stock to your Buy List at $30 and sell at $20? How can a stock become less attractive at two-thirds the former price?
A There is no shortage of ways to make money in the stock market, and having the discipline to follow a system is often more important than the system itself. Our system is designed to find stocks that have it all — attractive valuations, strong operating momentum, sturdy financial positions, and rising earnings estimates and share prices. Stocks with such attributes tend to outperform, and stocks relatively attractive on all such considerations tend to perform very well.

All else equal, I want to own cheap stocks with favorable operating, earnings-estimate, and share-price momentum. I’m willing to compromise if I think a stock brings diversity to a portfolio, or if I think a stock is so cheap that its appeal based on valuation makes up for less-than-stellar operating momentum. But I’m not willing to stick with a stock at $20 just because I liked it at $30. If a stock does not represent one of my favorite year-ahead picks today, I will drop it from the Buy List. Similarly, unless a stock is one of my favorite picks for two- to four-year returns, I will drop it from the Long-Term Buy List.

Q After last year’s huge losses in my 401(k) plan, how can I make up the lost ground?
A Don’t focus on getting back what you had at the market’s peak. Focus on what you’ll need for retirement, then devise a plan that will allow you to achieve that goal without taking excessive risk. If you have 10 or more years until retirement, holding most of your 401(k) plan in stocks makes sense. For now, we’d suggest keeping 30% to 35% of what you would typically hold in equities in short-term bonds, emphasizing high-quality corporate bonds if possible. Don’t take on extra risk to recoup what you’ve lost, and don’t take on so much risk that you will be forced to sell if the market slumps. If possible, boost your 401(k) contributions to the legal maximum; investing your income on a pretax basis is one of the most valuable tax breaks available.

Q Why don’t you recommend more stocks with high yields?
A Over the last 20 years, few strategies have destroyed as much wealth as chasing stocks with extremely high yields. Looking beyond the very highest yielders, the top one-fifth of stocks based on dividend yield have underperformed the average stock since 1992.
All else equal, I like stocks with decent yields and a history of rising dividends, partly because picking stocks based on dividend growth has been a winning strategy. But I see no reason to pick a less attractive stock because of an above-average yield. Remember, a company that pays out $1 per share in dividends has $1 less per share in cash available to invest in the business. If that company can earn a higher return on the money than you can, you’ll be better off if cash is reinvested rather than distributed in dividends.

Total return, not yield, is what matters. If you need to generate income from your investments, you are better off investing for total return and periodically selling some of your holdings to generate cash.

Q What do you do with your own money? Do you eat your own cooking?
A For the most part, the funds in my 401(k) are included in our recommended fund portfolios. Outside of my 401(k), I have nearly one-half my money in a separately managed account tied to the Best Ideas strategy of Horizon Investment Services, our sister company. The Best Ideas strategy is limited to my favorite stocks from Dow Theory Forecasts and Upside, a newsletter I edit that focuses on smaller stocks. My remaining money is held in mutual funds, with notable positions in Vanguard Intermediate-Term Tax Exempt ($13.31; VWITX), Vanguard High-Yield Corporate ($4.75; VWEHX), Heartland Select Value ($18.87; HRSVX), Heartland Value Plus ($18.97; HRVIX), and Baron Asset ($37.86; BARAX).


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