Bulls Blaze A Trail


After a year of considerable uncertainty, at least three conclusions seem clear heading into 2011:

The primary trend is bullish. With the recent close in the Dow Industrials above the Nov. 5 high of 11,444.08, the Dow Theory is squarely in the bullish camp. Both the Dow Industrials and Dow Transports have rallied to their highest levels in more than two years, echoing strength in the broad market. The bull-market reconfirmation, while not precluding a pullback in the averages, signals that investors should view the market’s next decline as a correction in an ongoing bull market.

Sentiment appears unusually optimistic. According to Investors Intelligence, 57% of advisory services are bullish, versus 21% bearish. The percentage of bulls has not been so high in four years, and the bull-bear spread of more than 36% is higher than about 96% of the weekly observations since 1989.

Similarly, 53% of investors surveyed by the American Association of Individual Investors (AAII) are bullish, the second-highest reading since May 2008. At 22.6%, the percentage of bears is the second-lowest since February 2007.

Sentiment surveys tend to reflect where the stock market has been — not where it is going. Nevertheless, history suggests extreme levels of bullishness represent a yellow flag. According to Birinyi Associates, when bulls in the AAII survey outnumber bears by 30%, the S&P 500 Index has tended to fall over the next six months.

Stocks are not particularly cheap — nor are they exceptionally expensive, especially considering the profit outlook and the yields available in the bond market. Among the small, midcap, and large stocks in the S&P 1500 Index, the median trailing price/earnings ratio is 18.2, meaning one-half of index components have a P/E above 18.2. That is slightly above the 16-year norm of 17.8 — and well above the median P/E of 10 at the March 2009 low.

Valuations are more attractive based on forecasts for 2011 earnings, which are expected to reach record levels for the S&P 500 Index. In fact, based on the consensus estimate for the index’s per-share earnings in 2011, the S&P 500 Index’s forward P/E is less than 14 — compared with the norm of 16 since 1956, according to Bloomberg. Based on the relationship between the S&P 500’s forward P/E and yields on corporate Treasury bonds, the stock market’s valuation is nearly as attractive as it has been in two decades, according to Bloomberg.

The stock market’s relative valuation is less compelling based on average dividend yields. But with dividend-payout ratios low versus historical norms and profits growing, brisk dividend growth is expected to continue. Indeed, the Federal Reserve says nonfinancial U.S. companies had $1.59 trillion in cash at the end of September, suggesting dividend growth could accelerate if companies gain confidence in the sustainability of the economic recovery. At 7.4%, the percentage of companies’ total assets in cash is at the highest level since 1959.


Today’s unusually bullish sentiment readings suggest stocks could be vulnerable to a pullback, especially if interest rates extend their recent surge. But with the primary trend squarely in the bullish camp, profits growing strongly, and valuations reasonable, a constructive stance toward equities remains appropriate. For now, our buy lists have 15.9% to 17.3% in Vanguard Short-Term Investment-Grade ($10.76; VFSTX), with the remainder in attractively valued shares of growing companies.

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