The Thrill Is Gone


Over the last century, the truly outstanding buying opportunities in the U.S. stock market have come amid widespread hatred for stocks. When everybody loved stocks, they tended to be fully priced and due for a fall.

While it seems clear Americans have fallen out of love with equities, we don’t think they’ve reached the hatred stage. Still, all our conclusions are subject to revision as evidence unfolds, and we’ll be watching indicators in three crucial areas as we adjust our recommended cash position:

Sentiment. Investors withdrew more than $33 billion from U.S. stock funds in the first seven months of this year — a pace that if sustained will make 2010 the second-worst year for withdrawals since the 1980s, trailing only the crisis year of 2008. Bond funds have attracted more money than U.S. stock funds for 31 consecutive months — the longest such streak since 1987.

Surveys of individual investors reveal increased skepticism regarding stocks as a long-term investment, and the percentage of bullish investment newsletters is below historical norms. But such sentiment surveys showed far more pessimism in late 2008 and early 2009, and investors are still allocating most of their retirement assets to stocks.

According to Hewitt Associates, a consulting firm that tracks pension plans, about 57% of the money in the 401(k) accounts it tracks is in stocks. While that is down from 70% two years ago, the typical retirement investor has not given up on stocks altogether.

Valuations. As we wrote on this page last week, the S&P 500 Index and the typical U.S. stock are slightly undervalued relative to 18-year norms based on trailing earnings. To match the trailing P/E seen at the March 2009 low, the median S&P 500 stock would need to drop about 30%.

At current prices, stocks are fairly cheap if you assume double-digit earnings growth will continue in coming years — and downright bargain-priced if you assume profit growth will continue and interest rates will remain near current levels.

The primary trend. Nothing says sentiment or valuations must revisit the lows of March 2009. But a breakdown below this year’s July lows is likely to depress sentiment further. The Dow Industrials have moved within 3.5% of their July closing low of 9,686.48, while the Dow Industrials are within 4% of 3,906.23. With closes in both averages below those points, the bearish primary trend would be reconfirmed. For now, we intend to watch the averages while holding 25% to 30% of equity portfolios in a short-term bond fund. For new buying, especially attractive names include Aflac ($45; AFL), IBM ($125; IBM), Lubrizol ($88; LZ), and Ross Stores ($50; ROST).

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