Cloudy Outlook Calls For Vigilance


From a massively destructive megastorm to an overwhelmingly bad September-quarter earnings season to the Nov. 6 election, things are unsettled on Wall Street. Stocks have been under pressure since earnings season began, reflecting lower-than-expected revenue and downbeat December-quarter guidance. But the major averages remain within 6% of this year's highs, and profit estimates for 2013 have held up surprisingly well. With so much up in the air, now is a good time to refocus on the basics of your approach. For our money, stock-market exposure depends mostly on four considerations:

The Dow Theory. The last important signal under the Dow Theory was bullish, with the Dow Transports confirming new highs in the Dow Industrials in February. Since then we have seen massive divergence between the averages, but the Dow Theory will remain in the bullish camp unless both averages move below significant lows. A breakdown below the June 4 closing lows of 12,101.46 in the Industrials and 4,847.73 in the Transports would represent a bear-market signal. Also, the Industrials have suffered a significant retracement of their June-to-October advance, so the low reached in the current pullback could become a significant point. On the upside, a rally above 5,368.93 in the Transports would be bullish.

Valuations. Ratios like price/earnings and price/sales have a poor record as market-timing indicators, but stocks tend to be cheap at market bottoms and expensive at market tops. Today stocks are neither, with the median stock in the S&P 500 Index trading at a trailing price/earnings ratio about 10% below the norm since 1994. Small and midcap stocks trade at narrower discounts. But it is hard to argue that stocks are richly valued — unless you think corporate earnings have peaked.

Investor sentiment. Bullishness tends to be rampant at market tops. Encouragingly, the percentage of bullish investment newsletter minus the percentage of bearish newsletters has dropped below 14%, down from nearly 30% on Sept. 16, according to Investors Intelligence. Sentiment among Wall Street strategists is quite bearish versus historical norms.

The opportunities available in individual stocks. While the broad market is not particularly cheap, the number of large-company stocks with modest P/E ratios compares favorably to historical norms. For example, 34% of S&P 500 stocks have
P/Es below 14, above the 18-year norm of 25%.


With attractively valued stocks available — and sentiment and valuations not suggestive of a market top — we intend to take our cue from the Dow Theory. For now, we're holding about 10% to 15% of our equity portfolios in a short-term bond fund.

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