Bullish on the Market, With Caution

Includes: IYE, IYF, IYG, IYM, IYZ
by: Ockham Research

Last summer, when the price-to-peak earnings multiple was hovering around eighteen, Ockham Research sounded like a broken record in warning readers that the market was at unsustainably high levels and was due for a pullback.

Well, there has indeed been a pullback and by mid-March the Dow Jones Industrial Average [DJIA] had lost more than 16% from its high posted just over 5 months prior. According to our value investing methodology, this rapid decline in stock prices has made the market ever more attractive. In February, we rated more than 90% of equities within our coverage universe a Buy, which was by far our most bullish stance since late 2002 in the aftermath of the tech bubble bust.

The stock market has begun to recover since the beginning of the second quarter. We are still quite bullish, but we see two particular sectors that we view as overbought. The energy (NYSEARCA:IYE) and basic materials (NYSEARCA:IYM) sectors performed better than most through the downturn and have continued to outperform the market during the nascent recovery. These sectors are up 34% and 30% respectively over the past year, while many other sectors have struggled to break even.

The worst performing sectors for the year so far are: financials (NYSEARCA:IYF), financial services (NYSEARCA:IYG), and telecom (NYSEARCA:IYZ)--all with near 30% declines. Our risk indexes have identified the energy and basic materials sectors as overbought, which makes the individual securities within those sectors less attractive by our methodology. Thus our overall ratings have moderated quite a bit since February, and they currently stand at 41.7% Buys, 42.8% Holds, and 15.5% Sells.

As you can tell from our historical ratings chart above, we still view this as a good time to enter the market. The market correction has exposed many undervalued stocks that have fallen out of favor unjustly. Valuations have returned to a more justifiable level, as they were unsustainably high for the better part of the last two years. Sentiment dropped very rapidly as fear gripped the market early this year, but our sentiment indicators are starting to noticeably change direction for the positive.

For those that have a long-term investment horizon, it is an attractive time to overweight your normal allocation of equities. Despite the fact that the market may have further downside before this bearish phase is over, in the long run, value will not be denied. To quote Benjamin Graham, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Disclosure: none