Proceeding with Caution Through Rallies

August 28, 2012

We would recommend caution at this time and to use rallies as an opportunity to reduce equity exposure where appropriate.
-Barry James, president, James Investment Research
-Trent Dysert, research assistant, James Investment Research

Even though it hit a new four year high, the S&P 500 later fell and had its first weekly decline since the beginning of July. The index fell 0.5% on the week. Smaller stocks, as represented by the Russell 2000, were down 1.3%. Weekly volume remains low and is about 25% lower than the weekly average for the year; a sign that investors still lack conviction in the markets.

There was an improvement in the housing data as existing and new homes sales edged higher. Back in June new single family starts were about 150 for every 100 sold. Today sales have improved, the ratio is now 135 starts for every 100 sold. Furthermore, prospective buyers are on the rise, an encouraging point for the housing market.

Mortgage applications for purchasing a home also improved, rising 0.9%. Refinancing had dominated mortgage applications over the past year but they fell 9.2% last week; one of the biggest declines this year. Could this be a lasting shift in the right direction for the housing market? It is too soon to tell.

As portfolio managers, we like to invest in bargain stocks, those with good relative value, strong profitability, and good relative price strength. This isn't merely using simple value characteristics, but they are a component. Value investing has a good long term track record, but you wouldn't know it this year. We have seen more expensive stocks (by P/E) beat their cheaper counterparts for seven consecutive months. Even more disturbing, they have beaten them by a very wide margin. This can be a sign of a risky market, as we saw in the late 90's and in 2007 - 08.

Earnings season is wrapping up and we have an opportunity to look back and compare the recent results with those from a year ago. Last year, S&P 500 earnings were growing about 16%; while sales were up 11.5%. Unfortunately, the 2nd quarter of 2012 wasn't so strong and results were troubling. We find sales growth was up a measly 0.6% while earnings growth was flat. We have seen slowdowns in Europe and China and though the U.S. economy is holding up better, the global slowdown is sure to have further impact here, especially with companies dependent on exports.

Our intermediate term indicators are trending unfavorable. We would recommend caution at this time and to use rallies as an opportunity to reduce equity exposure where appropriate.