Don't Abandon Ship

6/7/2010


While the market averages have stabilized somewhat, trading remains very choppy amid concerns regarding debt contagion in Europe and potential economic slowdowns in North America and Asia. Holding cash positions in line with the 15% to 17% of our Buy List and Long-Term Buy List seems prudent, but abandoning the stock market entirely seems like a mistake.

Favorable fundamentals

Recent readings on inflation, interest rates, and corporate earnings — widely viewed as among the most important drivers of stock prices — have been favorable. Yet the Dow Industrials have slumped nearly 9% from their April 26 closing high — including a 7.9% drop in May, the worst performance for the month since 1940.

Reflecting excess capacity and very modest growth in employment costs, inflation statistics show little pricing pressure. Excluding food and energy, U.S. prices rose 0.6% in the March quarter, the smallest increase since 1959. In late April the Federal Reserve reduced its inflation forecast for 2010 to a range of 1.2% to 1.5%, down from the 1.4% to 1.7% forecast in January.

Partly because of the mild inflation numbers, futures markets now indicate that the Fed is not expected to raise short-term interest rates until 2011. Yields on 10-year Treasury bonds have dropped to 3.3% from 4.0% in early April, as the debt problems in Europe have triggered a flight into the perceived safety of U.S. Treasury bonds.

Meanwhile, expectations for U.S. profits continue to climb, and all 10 sectors of the U.S. stock market are expected to deliver earnings growth over the next 12 months. According to Thomson Reuters, per-share earnings for the S&P 500 Index are expected to reach $85.26 in 2010 and a record $96.61 in 2011.

With the S&P 500 Index trading at less than 13 times the 2010 estimate and roughly 11 times the 2011 estimate, the index is moderately valued relative to historical norms. The median U.S. stock is even cheaper than the index, and high-quality stocks are unusually cheap relative to low-quality stocks.

Conclusion

Bears argue that expectations for earnings growth are wildly optimistic, that stocks are not cheap considering the risk of a double-dip recession in the U.S. Bulls argue that corrections are part of all bull markets, that stocks will get back on track as investors refocus on the favorable fundamentals.

We tend to side with the bulls, but we’re listening to the market for a contrary opinion. With a failed attempt at new highs in the Industrials and Transports and a retreat below this spring’s closing lows, a more defensive posture would be appropriate.


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