Big Rally Triggers Rethink

11/7/2011


After the biggest monthly gain in the Dow Industrials since 2002, a closer look at some of the key drivers of our stock-market exposure seems merited:

The Dow Theory. Because both the Dow Industrials and Dow Transports hit significant lows on Oct. 3, the rebounds since then have not changed the bearish indication of the Dow Theory. However, the rebounds easily qualify as significant, so the status of the Dow Theory is fairly clear.

If the averages suffer a significant correction without both closing below the Oct. 3 closing lows of 10,655.30 in the Industrials and 4,038.73 in the Transports, then both averages rebound above the highs established in the rally since Oct. 3, the primary trend would be regarded as bullish. If both close below the Oct. 3 levels, the primary trend would be reconfirmed as bearish.

The one potential wild card is an uninterrupted rally above this year's highs of 12,810.54 in the Industrials and 5,618.25 in the Transports. Such a breakout would require rallies of nearly 8% in the Industrials and 14% in the Transports from current levels. But a move above those levels would put the Industrials at multiyear highs and the Transports at all-time highs, which would make it difficult to argue the trend is bearish.

Valuations. As described in Value Focus, the capitalization-weighted S&P 500 Index is fairly cheap versus historical norms. Even more important, the typical S&P 500 stock is fairly cheap. As shown on the right, the median S&P 500 stock trades at 15 times trailing earnings, meaning one-half of S&P 500 stocks have P/Es below 15. That is well below the norm of 18 since 1995.

While many quality stocks are available at attractive valuations, stocks are no longer priced at bargain-basement levels. Fortunately, companies are not delivering bargain-basement earnings growth. As shown on the right, year-to-year profit growth remains impressive for the median S&P 500 stock. So far, the reaction to September-quarter results has been mostly encouraging, except for the financial sector.

Investor sentiment. Sentiment surveys no longer reflect abject hopelessness, as the latest rally has pushed some portfolio managers, newsletter editors, and individual investors into the bullish camp. But the surveys show sentiment is far from optimistic, and mutual-fund inflows suggest individuals remain very skeptical of stocks.

Conclusion

While the extreme volatility of recent months has been unsettling — and we would not be surprised by a meaningful pullback from current levels — we intend to look for buying opportunities on a stock-by-stock basis. For now, as a partial hedge, about one-fourth of our buy lists are in a short-term bond fund.


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