Keep Some Cash On Sidelines

12/7/2009


As repeated on this page many times, the key drivers of stock prices are earnings, inflation, interest rates, and investor sentiment. To summarize:

Year-to-year comparisons for corporate earnings are expected to turn positive in the December quarter. Bottom-up consensus estimates predict operating earnings for the S&P 500 Index will climb more than 20% in both 2010 and 2011.

Inflation remains quiescent, and the considerable slack in the U.S. economy suggests pricing pressures will remain muted in the near term.

Yields on two-year Treasury bonds are near all-time lows. Yields on long-term Treasury bonds are near six-month lows — and are close to 50-year lows excluding the deflation scare of late 2008 and early 2009.

Sentiment indicators reflect rising bullishness. According to Investors Intelligence, the percentage of bearish newsletters has dropped to 16.7%, the lowest proportion since June 2003.

Considering these seemingly bullish summaries, some may wonder why we’re holding 20% to 25% of our equity portfolios in short-term bonds. Our explanation comes in four parts:

First, we’d like to see a Dow Theory bull-market signal before committing the remainder of our cash. We’d like to see the Dow Industrials and Dow Transports suffer significant corrections without violating the March lows, then rebound above previous highs. Historically, holding some cash on the sidelines pending such a bull-market confirmation has been prudent.

Second, we’re concerned that consensus expectations for earnings are too optimistic. With S&P 500 Index earnings expected to climb more than 20% and the U.S. economy expected to grow more than 2.5% in 2010, exceeding expectations will be more difficult for companies in the year ahead.

Third, if the U.S. economy does gain traction in 2010, we’re worried that inflation and interest rates could surprise to the upside. Historically, stocks have not done well in the first year after economic growth resumes, partly because such growth is typically accompanied by tightening from the Federal Reserve.

Fourth, a shortage of bears is bad news for stocks. Stocks perform best when bullish sentiment is rising. But when sentiment reaches levels of extreme bullishness, it’s hard for bullish sentiment to continue rising.

Conclusion

Holding 20% to 25% of your stock portfolio on the sidelines seems prudent. With the remaining 75% to 80%, emphasize high-quality stocks with solid growth prospects and good Quadrix Overall scores. Top picks include Aflac ($46; AFL), BMC Software ($39; BMC), and DirecTV ($32; DTV).


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