Has Thirst For Risk Been Sated?

9/21/2009


Helped by upbeat economic data and favorable earnings guidance, the averages have moved to new highs for this rally. Also helping are widespread fears of missing a bull market, which have triggered a jump in mutual-fund inflows and a shift toward riskier investments.

At some point, we expect that events will conspire to remind investors that risk can be a bad thing, leading to a market correction and a shift toward higher-quality stocks. So, we’re holding about 30% of equity portfolios in a short-term corporate bond fund and emphasizing attractively valued shares of high-quality companies.

Grounds for concern

The S&P 500 Index has rallied more than 57% from its March low, and the typical U.S. stock has gained even more. Sentiment indicators reveal fairly widespread bullishness among individuals and institutions, and technical indicators suggest stocks are overbought.

Valuation gauges also provide grounds for concern. The S&P 500 Index trades at more than 18 times 10-year average earnings — up from 12 in March and above the long-term norm. Excluding price/earnings ratios above 75 or below 0, the average trailing P/E ratio of the small, midsized, and large stocks in the S&P 1500 Index is 19 — only slightly below the norm of 21 since 1994.

Considering that backdrop — and the fact that the last confirmed signal under the Dow Theory was the move to new lows in March — some subscribers have questioned why we are not reducing our stock-market exposure. Our answer has three parts:

First, the bulls are right to point out the huge amount of money still on the sidelines. U.S. money-market funds, which now yield next to nothing, recently held more than $3.5 trillion — down from $3.8 trillion in March but still far above historical norms.

Second, while the average U.S. stock has soared since March, the high-quality stocks we favor have not kept pace. The first stage of a bull market is often led by low-quality stocks, but relative performance since March has been extreme by historical standards. As a result, shares of companies with strong finances and track records are relatively cheap.

Third, the mostly large-capitalization stocks on our Buy List and Long-Term Buy List could play catch-up in coming months. With investors looking to play offense, small-company stocks have done best since March. As shown below, large stocks now trade at a discount.

Conclusion

Especially if the market corrects, we expect our high-quality and mostly large-company stocks to outperform over the next year. Among large stocks, IBM ($119; IBM) seems particularly attractive.


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