Losing Streak Worries Bulls

6/13/2011


Hurt by a string of worse-than-expected economic reports, the Dow Industrials and Dow Transports have slumped to 10-week lows. Because the Dow Theory remains in the bullish camp and quality stocks are available at reasonable valuations, we're maintaining a mostly invested posture. As a partial hedge, our buy lists have 12% to 13.5% in Vanguard Short-Term Investment-Grade ($10.81; VFSTX), a relatively low-risk bond fund.

Dismal science

Economic reports, including a dismal employment report for May, indicate growth has slowed. Economists have ratcheted down expectations for U.S. gross domestic product, with consensus forecasts now calling for annualized growth of roughly 2% for the first half of 2011 and 3% for the second half.

Interestingly, consensus profit forecasts for the September and December quarters have moved higher in recent weeks, as have revenue expectations. Year-to-year earnings growth for the S&P 500 Index is expected to slow to 14.4% for the June quarter, then reach 17.5% to 18% in the September and December quarters. Since April 1, consensus forecasts for full-year 2011 have increased for eight of the 10 sectors in the S&P 500 Index.

Are analysts merely behind the curve, slow to incorporate the latest round of economic data? Or are the bears placing too much emphasis on the U.S. economic slowdown?

To some extent, the answer to both questions is probably yes: Consensus profit forecasts do not fully reflect the latest "'soft patch" of data, but the bears are wrong to assume that a slowdown to 2% U.S. growth is enough to halt the bull market. After all, stock valuations do not seem to reflect expectations of robust growth:

• The S&P 500 Index trades at less than 13 times expected year-ahead earnings, below the norm of the past two decades. Based on the relationship between investment-grade corporate bond yields and the S&P 500's P/E, stocks are cheaper than they've been in more than a decade.

• The median S&P 500 stock trades at less than 17 times trailing earnings, lower than nearly three-fourths of the monthly observations since January 1992. Even on the broader S&P 1500, the median trailing P/E is less than 18 — slightly lower than the norm since the index's 1994 inception.

Conclusion

While a robust U.S. economy is not necessary to sustain the bull market in U.S. stocks, a relapse into recession or a sharp slowdown in expected corporate earnings growth would be undeniably bad news. For now, we intend to watch events unfold with a mostly invested equity portfolio.


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