The Risk-Reward Trade-Off

7/20/2009


As a partial hedge, we’re keeping about 30% of our recommended equity portfolios in a short-term bond fund. As always, this percentage hinges on two considerations:

The primary trend. Under the Dow Theory, the last confirmed signal remains in force until proved otherwise. The primary trend was indisputably bearish in early March, when both the Dow Industrials and Dow Transports reached multiyear lows. Since March the averages have experienced one of two things: (1) a fairly typical bear-market rally or (2) the first stage of a new bull market.

Until the averages prove the trend is bullish — suffering significant corrections without new lows in both averages, then rebounding above previous significant highs — the Dow Theory will remain in the bearish camp. For Dow Theorists, today’s key question is whether the averages’ recent pullbacks qualify as significant corrections.

The duration of the Industrials drop from June 12 to July 10 fits the parameters of a significant correction. But the Industrials retraced only 29% of their March-to-June rally, while the Transports retraced 32%. In general, significant corrections retrace 33% to 67% of the previous advance.

The opportunities available in individual stocks. Excluding unprofitable companies and those with price/earnings ratios above 75, the median S&P 1500 stock trades at 14 times trailing earnings — below the 14-year norm of 18. Also, the high-quality stocks we tend to favor are trading at historically cheap relative valuations.

As shown below, the average trailing P/E ratio of S&P 1500 stocks with Quadrix Quality scores above 70 is 10% below the average of all S&P 1500 stocks — among the biggest discounts since early 1995. S&P 1500 stocks with Quadrix Momentum scores above 70 trade at a 1% premium, below the 14-year norm of an 8% premium. Quality scores reflect track records and returns on assets, equity, and investment. Momentum scores reflect recent operating results.

Conclusion

For our money, setting stock-market exposure should be a matter of playing the probabilities. Rather than making a prediction and an all-or-nothing bet on that prediction, we weigh potential reward versus the risk of loss. Until the Dow Theory returns to the bullish camp, holding an above-normal cash position seems an appropriate way to mitigate downside risk. However, partly because quality stocks are available at reasonable valuations, we’re comfortable holding about 70% of equity portfolios in stocks.


INDUSTRIALS AND TRANSPORTS

 

QUALITY AND MOMENTUM LEADERS
TRADING AT ATTRACTIVE VALUATIONS

Average relative trailing P/E ratio of S&P 1500 stocks
with Quadrix Quality scores above 70

Average relative trailing P/E ratio of S&P 1500 stocks
with Quadrix Momentum scores above 70


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