Averages In Deliberation Mode


Have stocks rallied because of a lasting turn in the outlook for corporate cash flows? Or has the market merely staged a massive bear-market rally after a huge decline, like the 48% rally that followed the 1929 crash?

The answer, according to the Dow Theory, lies in the action of the Dow Industrials and Dow Transports. When both are moving above previous significant highs, the primary trend is bullish — and higher stock prices are likely.

As we see things, the averages are in the process of establishing significant highs. Some view the May 6 high in the Transports and June 12 high in the Industrials as significant, arguing that the Dow Theory turned bullish when those highs were surpassed.

We disagree, mostly because the corrections that followed the May and June highs failed to retrace even one-third of the advances since March. Whether we’re right or wrong, the averages will at some point suffer significant corrections. If both are able to rebound to reach new highs, we’ll know the Dow Theory is bullish.

In the meantime, we’re searching for attractively valued stocks — and looking for perspective anywhere we can find it. Measures of market valuation are poor timing indicators but can help put things in perspective, as bull markets tend to begin when stocks are cheap and end when stocks are expensive.

The S&P 500 Index, which represents about 75% of the total value of U.S. stocks, has gained 49% since March 9 and now trades at more than 18 times expected 2009 earnings — not particularly cheap versus historical norms and above the level at the market peak in October 2007.

If you accept consensus profit estimates for 2010, which call for a 35% increase in total profits from S&P 500 companies, the S&P 500 Index is arguably cheap at less than 14 times earnings. Consensus forecasts for 2010 anticipate profit gains exceeding 60% for the consumer-discretionary, energy, financials, and materials sectors — targets these sectors will be hard-pressed to meet without substantial improvement in the global economy and the U.S. labor and housing markets.

If you look at stock values one at a time — rather than summing them together as is done for the S&P 500 Index — the picture is brighter. Excluding unprofitable companies and those with price/earnings ratios above 75, the median S&P 500 stock trades at about 14 times trailing earnings, below the 15-year norm of 18.


While attractive values are available, it is difficult to argue that the stock market is bargain-priced — unless you expect a lasting turn in corporate earnings. Until the Industrials and Transports confirm that such a turn has occurred, we intend to hold a good portion of our equity portfolios in a short-term corporate bond fund. For now, we’re holding about 30% of our buy lists in Vanguard Short-Term Investment-Grade ($10.39; VFSTX). With the remainder, we’re emphasizing attractively valued shares of companies positioned for growth.

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