Wall Of Worry Crumbles

8/10/2009


Amid rising bullishness, the market has extended its rally. Some Dow Theorists view the rally above the highs reached in May and June as a bull-market signal, but we don’t think the pullback in June and early July was severe enough to qualify the May and June highs as significant.

A more substantial correction seems likely in coming months, and the market’s ability to rebound from such a correction will be crucial. For now, our plan is to watch the averages while looking for opportunities in individual stocks. As a partial hedge, we’re holding about 30% of equity portfolios in Vanguard Short-Term Investment-Grade ($10.35; VFSTX).

Bullishness on the rise

For many investors, the market’s surge since early July has settled things nicely. Nearly all the major averages are trading at the highest levels since October. Corporate profits are coming in stronger than expected, and the economy is showing clear signs of recovery.

Inflows into mutual funds have surged, reflecting rising bullishness among individual investors. According to the American Association of Individual Investors, the percentage of bulls has jumped to 60%, up from about 34% less than a month ago.

Professional investors are also feeling confident. According to a Reuters poll of institutional investors, managers of balanced funds have lifted their exposure to equities to the highest level since August 2008. Cash levels have dropped dramatically and are now at the lowest level since May 2007.

Among newsletter editors, the percentage of bulls has rebounded to 47% — near the highest levels of the past 18 months, according to Investors Intelligence. The ratio of bulls to bears is about 1.8, versus 1.0 three weeks ago.

Stock selections

Historically, the stock market performs best when investors are skeptical. With skepticism in increasingly short supply — and stocks overbought based on our intermediate potential risk indicator and other measures — moving to a fully invested posture at this point seems imprudent.

Excluding unprofitable companies and those with price/earnings ratios above 75, the average stock in the S&P 1500 Index of large, medium-size, and small stocks trades at 19.5 times expected current-year earnings — above the five-year norm of 18.9. With stocks no longer particularly cheap, the market will be vulnerable if consensus projections of brisk profit growth next year come into question. To hedge this risk, we’re emphasizing attractively valued shares of reliable growers. Top picks include CVS Caremark ($34; CVS) and Hospira ($40; HSP).


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