While most economists appear confident that the current "soft patch" in the U.S. economy will give way to decent growth, investors are not so sure about U.S. stocks. Surveys of individual investors, advisers, and money managers reveal a sharp decline in bullishness over the past six weeks, and U.S. equity funds have seen a surge in outflows since early May.
With investors running scared, the risk of a more substantial near-term correction should not be discounted. A typical secondary correction retraces one-third to two-thirds of the preceding advance, and the Dow Industrials and Dow Transports have retraced only one-third of their rallies from the August lows. Two-thirds corrections would put the Industrials at 10,925 and the Transports at 4,565.
Such a decline would put the market's valuation at fairly modest levels, unless the outlook for corporate profits deteriorates considerably. Indeed, with the S&P 500 Index trading at 13 times expected 2011 earnings and yields on 10-year Treasury bonds near 3%, many argue that stocks are already comparatively cheap. The median S&P 500 stock trades at 16 times trailing earnings, lower than nearly 80% of the month-end observations since January 1992.
Clearly, investors are skeptical of consensus profit forecasts, which call for at least 14% year-to-year profit growth for the S&P 500 Index in each of the next three quarters. In 2012, the consensus projects a 13% increase, with all 10 sectors except health care and utilities expected to post double-digit growth. While we tend to side with the optimists on profits, skeptics see valid reasons for concern around the globe:
• First is the chronic sluggishness of the U.S. economy, which has responded to massive fiscal and monetary stimulus with plodding growth. While continued economic sluggishness would not mean the end of the bull market, a relapse into recession almost certainly would.
• Also worrisome is slowing growth in developing markets like China, Brazil, and India, which have accounted for much of the recent growth in the global economy. Worse-than-expected inflation news in these nations would be bearish for U.S. stocks, as pricing pressures will force central banks to keep raising interest rates.
• Meanwhile, Europe faces the risk of a default by Greece and possibly Ireland and Portugal, while strife in the Middle East threatens to spark another jump in oil prices. An unmanaged near-term default by Greece is unlikely, as European authorities seem aware of the potentially contagious and disastrous effects of such a move. Handicapping the potential for another oil shock is nearly impossible, but Saudi Arabia has signaled its desire to make up for any production shortfalls.
While the global outlook is murkier than usual, stocks are seldom attractively priced when everything looks rosy. Moreover, the last significant development under the Dow Theory was the move to new highs in the Dow Industrials and Dow Transports this spring.
A move to new highs above 12,810.54 in the Industrials and 5,527.50 in the Transports would reconfirm the bullish trend. If the market rallies meaningfully but fails to reach new highs in both averages, then slumps below the closing lows reached in the current correction, the Dow Theory would shift into the bearish camp.
For now, we're maintaining a mostly invested equity portfolio while monitoring the averages and the outlook for corporate profits. As a partial hedge, our buy lists have 12% to 13.5% in Vanguard Short-Term Investment-Grade ($10.78; VFSTX). For new buying, top picks include our Capital-Gains Favorites. Among funds, Vanguard Dividend Growth ($15.20; VDIGX) offers a top choice.