IRA Investing: Modest Improvement in Indicators

Richard Moore, CFA, writes about strategies for asset allocation in IRAs.

The market continues to dole out punishment to most investors as it tries to figure out the most likely future economic landscape.

I believe, initially, that the market is in the process of discounting the expected economic slowdown or recession.

In addition to that problem, the market is discounting a probable increase in the inflation rate.

Finally, the market is discounting a likely Obama victory (that could also bring a large Democratic majority in the Congress) and the concomitant increase in capital gains and dividend tax rates along with increasing regulation and curtailment of foreign trade.

These are substantial problems that will take time to resolve.

As a guide to how close we might be to fully discounting these problems, I use mainly sentiment indicators to make asset allocation decisions. Since two weeks ago, there has been some modest improvement as the market has continued to be choppy. One continuing problem indicator is the ratio of Nasdaq volume to NYSE volume.

This indicator is in negative territory and has been running between 1.4 and 1.5 recently. This means there is still too much speculation in the market and the indicator needs to decline to 1.3 to be neutral and to 1.2 to be bullish.

Similarly, the ratio of odd-lot sales to odd lot purchases has not really improved much in the recent decline and the indicator remains neutral. A comparison of money flows into bearish Rydex Funds compared to the flows into bullish funds has improved recently but is still neutral. Also in neutral territory is the ratio of odd lot short sales to odd lot purchases.

On a more optimistic note, the difference between confidence levels of smart investors compared to dumb investors remains bullish and probably will turn extremely bullish if the market stays choppy this week.

Finally, let's look at the put/call ratio for individual equities on the CBOE:

Click here for larger image.

This is a five-year chart of the detrended CBOE individual put/call ratio shown in red. Detrended means that I am comparing the latest 10-week moving average of the indicator with its 52-week moving average.

The S&P 500 is shown in black and the green lines represent longer-term indicator trends and standard deviations. This indicator was not particularly good at forecasting the current market decline. Nevertheless, current levels of put buying compared to call buying are now at extreme levels above 1.1 and this indicator is very bullish.

In the context of a continuing long-term neutral outlook, these indicators mean that I am decreasing my cash target from 40% to 35%. I would anticipate further market volatility but feel that a modest reduction in cash position is appropriate now. The actual cash position in my IRA as of the end of last week was 39.5%.

Since two weeks ago, I have eliminated my position in URSURS Corp. The company reported earnings last week that were basically on target. However, the company's forecast for 2008 was disappointing because of the company's apprehension about the ability of state and local governments to fund infrastructure projects. I took a new position in Stepan Co.SCL.

Stepan is involved in the manufacturing and sale of specialty chemical products used in surfactants (for example, detergents or emulsifiers), polymers and other specialty products.

The company has been an underachiever, growing sales at an average annual rate of 12.2% over the past five years but showing a negative growth in earnings of 5.8% over the same time period. 2007 was a good year as the company recorded a 13% increase in sales for the year and a 19% increase in the fourth quarter.