Fear And Greed

8/29/2011


The smart money, according to one long-lived Wall Street proverb, buys when blood is in the streets. Legendary investor Warren Buffett has long preached that you should "try to be fearful when others are greedy, and greedy when others are fearful."

Yet a large body of evidence suggests that investors do exactly the opposite, dumping stocks near market bottoms and buying when prices are high. According to financial research firm Dalbar, U.S. mutual-fund investors realized a 2.3% annualized return between 1990 and 2009, versus 8.2% for the S&P 500 Index. Much of the return gap reflects panicked selling at market bottoms, which caused fund investors to miss out on subsequent rebounds.

Outflows from stock funds recently reached a nearly three-year high, and stock funds have seen a net outflow of $400 billion since 2006. So, it seems safe to conclude that investors today are not especially greedy, especially considering their continued shift into low-yielding bond and money-market funds. Still, just because investors are fearful does not mean they could not become more fearful in the near term.

To reduce the risk of a premature return to a fully invested posture, we consider investor sentiment, valuations, and the action of the Dow Industrials and Dow Transports.

• As described in Investor Sentiment, sentiment is depressed but not at the level of abject surrender seen at times during 2008, 2009, and even 2010. We'd be more bullish on the market if newsletter editors and other advisers were more bearish.

• Valuations are attractive, with average price/earnings ratios at a substantial discount to 15-year norms. But, before concluding stocks are truly cheap, we'd like to see more evidence that today's record profit margins are sustainable in a slow-growth environment.

• Recent market action has provided some grounds for hope, as the Industrials have avoided a breakdown below the Aug. 10 closing low of 10.719.94. The longer the Industrials can hold above that point, the more significant the point will become. A move above the Aug. 15 closing levels of 11,482.90 in the Industrials and 4,684.44 in the Transports would be encouraging, at least on a short-term basis.

Our current plan

With the last signal under the Dow Theory a bear-market confirmation, we intend to watch the averages while looking for opportunities on a stock-by-stock basis. Reflecting this week's addition of CF Industries ($179; CF), our Buy List now has 21.3% in Vanguard Short-Term Investment-Grade ($10.72; VFSTX). Our Long-Term Buy List has 26.3% in this relatively low-risk bond fund.


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