Our Advice: Worry, Don't Sell
Because of a pullback in commodity prices and some disappointing economic reports, investors are playing defense. The Dow Industrials have slumped 2% from the nearly three-year closing high of 12,810.54 on April 29, while the Dow Transports have dropped nearly 2% from the all-time high of 5,527.50 on May 10.
The Russell 2000 Index of small stocks, which is highly sensitive to expectations for the U.S. economy, has dropped nearly 4% from its April 29 high. Yields on 10-year Treasury bonds, seen as a safe haven, have dropped to a new low for 2011 below 3.2% — down from nearly 3.6% in early April.
Defensive sectors have outperformed since early April, and health care, utilities, and consumer staples now rank among the top four for year-to-date returns. Meanwhile, the cyclical materials and energy sectors have slumped more than 5.5% since peaking April 29.
Also worrying some is the recent outperformance of growth stocks relative to value stocks. Relative strength in growth stocks, which tend to have higher growth rates and richer valuations, can signal that investors are anticipating a slowdown in the economy. With U.S. economic growth already near stall speed — gross domestic product grew at an annualized rate of 1.8% in the March quarter — bears worry about a relapse into recession.
Tilting the odds
Worrying about a relapse seems prudent, as there is no doubt a recession would surprise Wall Street. Consensus estimates still project at least 3% annualized U.S. economic growth through the final three quarters of 2011. But worrying and selling are two different things, and you can take steps to tilt the odds in your favor:
• First, use a diversified blend of factors to grade stocks. Assuming weekly rebalancing since year-end 2009, the top 10% of S&P 1500 stocks based on Quadrix scores for Earnings Estimates, Financial Strength, and Performance have underperformed the average stock. Top Value scorers have outperformed handily, while Momentum and Quality leaders have moved ahead of the average stock because of gains this year.
Top stocks based on Overall score, which reflects a weighted average of the six category scores, have nearly matched the top Value scorers — with less volatility. By looking for stocks with broad-based appeal, you can enhance returns without the volatility associated with single-minded approaches like buying only the cheapest or fastest-growing stocks.
• Second, consider the big picture. Nine months ago, growth stocks were unusually cheap relative to the market and to historical norms. Today the average growth stock in the broad Dow Jones U.S. Stock Index has a trailing P/E of 25, only slightly below the 19-year norm of 26. The average value stock has a P/E of 18, versus the norm of 17.6. Growth stocks average an Overall Quadrix score of 60 versus 56 for value stocks, but both are roughly in line with long-term norms.
With neither growth nor value particularly attractive relative to historical norms, investors should be looking for opportunities among stocks of all stripes. Among sectors, technology and health care continue to score favorably in Quadrix, while a growing number of energy and materials stocks earn top scores.
• Third, spread your bets. Don't let a single stock or sector dominate your portfolio's returns. By diversifying among top-rated stocks in a broad range of both cyclical and defensive groups, you can lower risk without diminishing expected return.
• Fourth, look for category killers — stocks with attributes attractive to both growth and value investors. Listed below are eight stocks from our Buy List. The four labeled value stocks have strong operating momentum, while the four growth stocks earn above-average Quadrix Value scores.
• Fifth, watch the averages. The Industrials and Transports reached significant highs within the past month, keeping the Dow Theory in the bullish camp. If one or both averages fail to rebound to new highs after a correction, we may raise some cash. For now, our buy lists have 9% to 11% in a short-term bond fund.