Valuations Favor Stocks


After slumping steadily since Election Day, stocks have bounced on optimism that a jump off the fiscal cliff can be averted. The Dow Transports remain within 3% of their June closing low of 4,847.73, while the Dow Industrials are more than 5% from their June low of 12,101.46.

Closes in both averages below the June lows would cause us to adopt a more defensive posture. A rebound above the February high of 5,368.93 in the Transports and the October high of 13,610.15 in the Industrials would be bullish — and a reason to increase our stock-market exposure.

A failed retest of the October high in the Industrials could complicate things under the Dow Theory, as it would mean the Industrials could establish a significant low above the June low. Still, our strategy is unchanged: Subscribers should watch the averages and hold about 10% to 15% of equity portfolios in a short-term bond fund.

With a breakdown below the June lows, our bond-fund position is likely to climb to at least 25%, meaning we could still have 75% of our equity portfolio in stocks. That may seem like a lot of exposure to stocks after a bear-market signal, but we are not fans of all-or-nothing timing — and generally hold at least 60% of our equity portfolios in equities. Also, we expect stocks to outperform bonds handily over the next five to 10 years.

Relative to today's depressed bond yields, dividend and earnings yields on stocks are very attractive relative to historical norms. Even relative to their own historical norms, stocks are cheap. For example, as shown on the right, the average trailing price/earnings ratio among stocks in the S&P 500 Index is 16.9, below the norm of 20.7 since October 1994. Only 6% of the months since October 1994 had a lower average P/E.

The S&P 500's median P/E ratio (the P/E that divides the 500 stocks into two equal-numbered groups) tells a similar story, as do the averages and medians for the S&P MidCap 400 and S&P SmallCap 600.

Bears contend that stocks look cheap only because of today's unsustainably high profit margins, which have lifted corporate earnings to record levels. Stocks are not particularly cheap based on price/sales ratios, so valuations won't look nearly as attractive if margins begin trending lower.

So far, however, margins for the typical U.S. company are holding up well. In fact, for the September and June quarters, a majority of the more than 1,500 companies in the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes saw year-to-year increases in net profit margins. The same is true based on gross margins and operating margins. Just as it seems premature to conclude the primary trend is bearish, it seems premature to conclude the uptrend in corporate profits has been halted.

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