Bearish Trend Confirmed


The Dow Industrials closed below the August low of 10,719.94, confirming a similar move in the Dow Transports and reconfirming the bearish primary trend under the Dow Theory. While the breakdown in the Industrials is discouraging — and we are decreasing our stock-market exposure this week by dropping BlackRock ($148; BLK) — we are not making a wholesale move out of stocks.

For now, our buy lists have about 25% in Vanguard Short-Term Investment-Grade ($10.63; VFSTX), a relatively low-risk bond fund. Of the portion of your portfolio allocated to equities for the long haul, we suggest you limit stock-market exposure at roughly 75%. If 75% seems high given the bearish reconfirmation, consider the following:

We're not all-or-nothing market timers. Shifting between 100% and 0% stock-market exposures is among the best ways to wreck your long-term returns, and we expect stocks to handily outperform bonds over the next decade. As a rule, we are unlikely to cut our stock-market exposure below 60%.

Stocks appear oversold, and investor sentiment is extremely pessimistic. Only 14% of NYSE stocks are trading above their 200-day moving averages, among the lowest readings since the market bottomed in March 2009. More than 45% of newsletters monitored by Investors Intelligence are bearish, the highest percentage since March 2009. With so many stocks down sharply and so many investors bearish, a little good news on Europe, the economy, or earnings could trigger a meaningful near-term bounce.

On average, stocks are fairly cheap. The S&P 500 Index trades at 10 times consensus 2012 profit estimates. Investors are rightly skeptical regarding the 2012 consensus, which calls for 13% growth. But the forward P/E is already below the norms seen in economic downturns over the past 50 years, according to Bloomberg. Based on trailing earnings, the average stock in the S&P 500 has a P/E of 15.5, below the norm of 20.5 since January 1990.

Cheap stocks are plentiful. The number of S&P 500 stocks with trailing P/Es below 12 has surged to 171 — the highest since June 2009 and above the norm of 80 since January 1990. Of course, P/Es can be misleading when profits are set to fall, so 2012 guidance will be especially crucial as third-quarter results are announced over the next few weeks.

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