Grounds For Concern


We see several reasons for near-term concern regarding the U.S. stock market, beginning with its discouraging reaction to June-quarter results.

• While earnings season began with some high-profile positive surprises, the broad market has moved lower as more companies have reported.

• Even before the reporting season began, market breadth had deteriorated markedly. The S&P 1500 advance-decline has not reached a new high since May 18. Among the 10 major capitalization-weighted sector indexes for the S&P 1500, only the consumer discretionary, financials, health care, and technology sectors have reached new highs since April.

• If the slowdown in China morphs into an outright recession, the impact on the outlook for global economic growth would be severe. Is that a real threat? The Chinese government does not admit as much, as it is still projecting 7% economic growth for this year. But its vigorous and somewhat panicked response to its stock-market meltdown suggests real concern regarding the risk of a downturn, and few Western economists have much faith in China's official economic data. Commodity investors seem to be taking the threat of a Chinese slowdown very seriously. The Thomson Reuters/Core Commodity CRB Index is down more than 8% since the end of June, while oil prices are down more than 17%.

Five things to do now

Liquidating your stock portfolio every time you see reasons for concern is a surefire way to earn poor long-term returns, so you need a disciplined way to translate your concerns into action. As you plot your strategy today, we'd suggest five steps.

First, hold some extra cash in your stock portfolio. Reflecting recent downgrades, our buy lists now have 21.9% to 22.7% in Vanguard Short-Term Corporate Bond ($80; VCSH), which we use as a substitute for cash. While we will put some money back into the stock market if we see opportunities, we intend to hold some extra money on the sidelines unless the bull market is reconfirmed under the Dow Theory.

Second, sell stocks that no longer rank among your favorites. While it is difficult to sell stocks you could have sold higher just weeks or months ago, that emotional pain should have no bearing on your decision to hold or fold. Ask yourself if a stock you own is one you would buy today. If the answer is no, you should sell.

Third, keep looking for buying opportunities. Even when the trend is clearly bearish, smart investors are always looking for good buys. Otherwise, you won't know if the stocks in your portfolio still rank among your favorites. We don't believe in timing the market in an all-or-nothing fashion, and we're very unlikely to ever have more than half of our buy lists in cash.

Fourth, consider how you might react to a market downturn. While it is impossible to know how you will feel in the future, consider how you might react to a 20% decline. If your financial circumstances or emotional makeup make it likely you will need to sell after such a drop, you should sell at least a portion of your portfolio now.

Fifth, watch the averages. The Dow Theory does not always work. But it typically provides an unambiguous verdict on the market's direction and does a good job of identifying bear markets. Before a recent bounce, the Dow Transports hit a series of important lows in April, May, and June. So, if the Dow Industrials close below this year's closing low of 17,164.95, we'd view that as confirmation that the primary trend has turned bearish. With a bear-market signal, our cash position will climb to at least 25% to 35%.

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