Correction A Risk, But Don't Sell Yet


After reaching all-time highs in early August, U.S. stocks have dipped on profit-taking and worries regarding Federal Reserve policy. The Dow Theory is squarely in the bullish camp, and we are still finding reasonably valued stocks supported by solid profit-growth prospects. Our buy lists have at least 94% in U.S. stocks, with the rest in a short-term bond fund.

Unusual exuberance

When the stock markets takes a pause after going straight up for awhile, the temptation to look for a correction is understandable. That is especially true among those who have been fighting the market's advance, as a great many professional investors have been doing all year.

The stock market has appreciated at a much faster clip than corporate earnings or gross domestic product over the past two years, and many analysts seem convinced something is out of whack. That is one reason Wall Street strategists have been so reluctant to embrace the bull market.

Merrill Lynch's sell-side indicator, which shows the average equity allocation among Wall Street strategists, reached 52.3% in July. That is well below the 15-year average of 60.4%, but the current allocation is at a 15-month high and up from 49.8% before the June-quarter earnings season.

Sentiment among investment newsletters has also become more optimistic, with the percentage of bulls exceeding the percentage of bears by more than 32% in the latest survey by Investors Intelligence. While that is below the 36.4% reading in mid-May, Investors Intelligence says a spread above 30% is a cause for concern.

Surveys of individual investors still reveal a high level of skepticism. But mutual-fund inflows tell another story, with U.S. equity funds seeing a record inflow in July.

Historically, an unusually high level of optimism has signaled a higher-than-normal risk of a correction. But timing such corrections with precision is very difficult, and other indicators suggest a correction may not be imminent.

The percentage of New York Stock Exchange stocks trading above their 200-day moving average, historically a good gauge of the risk of a near-term correction, is not especially high at 64%. Another good sign: The broad market is keeping pace with the major averages, with advance-decline lines for the S&P 500 and S&P 1500 indexes reaching new highs this month.


At some point, stocks will correct, testing the market's bullish trend. But raising cash now seems premature, and we continue to recommend a nearly fully invested posture. Cognizant Technology ($74; CTSH) is a top pick.

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