The market gave us all something to cheer about last week as the
finally joined the
Dow Jones Industrials
in making a new all-time high. Even the Value Line Geometric Average, which attempts to measure the change in value of the average stock on the
New York Stock Exchange
, joined the party and hit a new high also. So with stocks taking a bit of a breather so far this week, many IRA investors might ask, isn't it time to sell?
It depends. I like to focus on two important long-term indicators that can tell us what the current environment really is -- beyond the simple observation that we are hitting new highs.
The first indicator is sentiment.
I like to feel that I am going against the crowd when looking at my asset allocation. Meaning I want to be doing the opposite of speculators and smaller, less-informed market participants.
Currently, as I have shown in several charts published over the last few weeks, odd-lot investors and short sellers in general are still quite pessimistic about the long-term trend of the market. Their high level of short selling indicates that they are still worried about a major market decline similar to the one that occurred in 2000 to 2002.
I have the distinct impression that these investors are currently looking at new market highs as a reason to be cautious because the market just can't continue to go up forever. This sentiment leads me to continue a bullish stance in my IRA.
If things were to change, and these same investors started to buy into the bull market in a big way by reducing their short positions and buying more aggressively, I would probably reverse myself. But that hasn't happened yet.
The second indicator is valuation.
Is the market substantially overvalued? I'm not an economist, and I don't attempt to forecast corporate earnings, but looking at market valuation currently, the market doesn't seem expensive.
One way I like to look at valuation is to compare bond yields with stock yields at the current time. The stock yield I am referring to here, though, is actually an earnings yield (the inverse of the P/E ratio, so a P/E of 20 equals an earnings yield of 5%).
has been publishing this statistic for many years, and it shows the ratio of high-grade corporate bond yields to the earnings yield of the
50 stock average.
Lets look at a chart of this statistic now.
This is a five-year chart of the S&P 500 in black and the bond yield/stock yield ratio in red. As a general rule, when the yield on bonds approaches twice that of the earnings yield on stocks, caution is warranted.
For example, if bond yields were to creep up to 8% and the earnings yield on stocks dropped to 4% (indicating a current P/E of about 25 times earnings), we could say that valuation was quite high.
On the positive side, when bond yields are about equal to stock earnings yields, valuation seems very low.
That is the current situation:
BOND YLD/STK EARNINGS YLD VS. S&P 500
This ratio is currently fluctuating very close to the level of one, indicating that a positive environment is in place for equity prices.
What could cause this ratio to increase and become more bearish? Clearly, higher bond yields that would probably be caused by increasing inflation would be negative. Also, decreasing corporate earnings that would cause P/Es to increase would be a negative.
Currently, though, this indicator is in a very positive position.
So my longer-term indicators are still bullish, even at these market levels. My intermediate-term indicators did not show any change last week, and all three remain neutral. This set of circumstances leads me to use a target cash position of 10% in my IRA, and my actual cash position at the end of last week was 11.6%.
My cash position actually increased last week due to my sale of
( SHS). I had held this stock for seven months, and it no longer appeared on my screening system as a buy. Therefore, I liquidated my position. I was not able to find a suitable replacement last week, but I am continuing to look for new ideas.
Last week was a good one for my IRA because I was able to pull ahead of the S&P 500 for the second quarter. Among the good performers was
, which was up more than 9% as the fertilizer industry continues to exhibit good momentum.
Another winner was
, which I just purchased a couple of weeks ago. The company reported earnings for the quarter ended April 30, 2007, that were substantially ahead of estimates, leading to an increase in price of 8.5% for the week. Even after the move last week, I still consider Layne Christensen to be a buy.
The following table shows the current holdings in my IRA:
At the time of publication, Moore was long all stocks in the IRA table, although positions may change at any time.
Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback;
to send him an email.