Factor Sector Under Pressure


With the Dow Industrials and S&P 500 Index within striking distance of all-time highs, some have questioned whether it makes sense to hold cash on the sidelines based on the continued sluggish action of the Dow Transports, a price-weighted average of 20 stocks. Our answer has six parts.

First, the Dow Transports are not giving a misleading signal about the health of the transportation group. Broader, capitalization-weighted gauges of transportation stocks have charted similar courses. Transportation indexes that don't include the airlines look even worse.

Second, transportation stocks tend to be a good barometer of the industrial economy, and other indicators confirm this part of the U.S. economy is laboring. The U.S. manufacturing sector expanded at its slowest pace in more than two years in October, according to the Institute for Supply Management's gauge of manufacturing activity. The ISM index has declined four straight months to 50.1, barely above the 50 level that indicates expansion. Manufacturing output, the biggest component of the Federal Reserve's industrial production index, has declined sequentially in two straight months — and in September was up just 1.4% from a year earlier.

Third, the industrial sector is still a crucial swing factor for gross domestic product and corporate profits. Manufacturing accounts for about 9% of U.S. employment, down from about 25% in the 1970s. But goods production, most of which is done by manufacturers, represents about 30% of U.S. gross domestic product.

Fourth, the sluggish action of the Transports is not the only fly in the ointment. While the broad market has participated in the rally from the August lows, big stocks have led the rebound. The S&P 1500 advance-decline line, a running daily total of advancing stocks minus declining stocks, has rebounded sharply but remains well below the highs reached in mid-July.

Fifth, we're also having a harder time finding attractive individual names, especially in areas where we don't already have ample representation. With profit growth sluggish and valuations somewhat expensive, finding stocks that fit our growth-at-a-good-price approach has become more difficult.

Sixth, we've trimmed our cash position meaningfully since early October, when both the Industrials and Transports rebounded above the significant highs that followed the market's initial rebound from the August lows. This week we're increasing by 0.2% the target weight for all the Buys and Long-Term Buys not on the Focus List, bringing the equity exposure of our Buy List to 81.4% and the Long-Term Buy List to 83.5%. Unless you can trade for free, you may want to target your buying toward the stocks furthest below our target weights rather than buy all the stocks for which target weights are rising.

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