A Time to Trim Weaker Stocks?

January 28, 2013

With the S&P 500 trading at 1503 stocks are now ahead about 12% since the mid-November rally began.
-Frank James, founder, James Investment Research

Stock Market Analysis

Stocks rose strongly last week, more than 2,000 advancing against fewer than 1,000 declining, while 794 stocks set new highs with only 32 new lows. MidCap and transportation stocks were standouts, and only the information technology sector declined. Commodity indexes were mostly lower. Gold stocks lost ground, now down $66 an ounce over the past year. The dollar pulled back a bit but is still ahead about 1% over the past 52 weeks.

With the S&P 500 trading at 1503 stocks are now ahead about 12% since the mid-November rally began. Ninety three percent of stocks are above their 50 day moving averages and beyond the top of their 40 week Bollinger bands, a sign the market is greatly extended.

Those who have followed our research are not surprised at Barron’s cover this week: “Manufacturing is at the beginning of an amazing comeback in the U.S. powered by low-cost natural gas at home...” The low energy story we earlier discussed has attracted billions in plant investment from firms around the world. Should the U.S. government not curtail, this will speed development around the country. Industrial production is said to increase 2.25% over the past year, and a slim 0.26% for December. Housing and autos are selling well. But consumers goods orders are flat. New industrial production orders and especially orders for business investment (nondefense capital goods ex air) are declining slightly.

Leading indicators are positive, up a strong ½ of one percent, yet the very accurate Coincident/Lagging index is down since July (90.4) and the latest reading (89.3) was another decline. The Economic Cycle Research Institute (ECRI) Weekly Leading Index grows at a healthy 7.2% rate, up from 6.1% last week, suggesting strength for the economy. Earnings season is upon us, and earnings are expected to grow at a good rate this quarter.

Consumers are beginning to revive a bit, and so is economic growth. Not much, but a slow economic revival which is putting more people to work, and consumers are shopping and spending. Washington attacks entrepreneurs with higher taxes and unfriendly regulations, yet in spite of this entrepreneurs are cautiously working to increase sales and profits. Lots of problems, of course, not the least is paucity of new orders and the shrinking export opportunities caused by recessions overseas. As one surveys the overall economy, it is difficult to escape the conclusion that growth in many sectors is present, but just above stall speed.

Yet the limited economic revival does not automatically lead to the conclusion that stocks are a “Buy.” As son David, our Director of Research is fond of pointing out, a fine company does not necessary identify a good stock buy. And stock prices often peak just when corporate earnings are at new highs. Should prices be too extended, and should sentiment become too euphoric, stock prices tend to retreat. Often rapidly.

A sentiment indicator we have followed for years is the Investors Intelligence Bulls to Bears index. Last September, the bullish differential was a high reading near 30. Stocks were rising from July until mid-September when prices peaked. As the differential broke lower, and not until then, did stocks fall back in a decline that lasted until mid-November, which set the stage for our present rally. Today the bullish differential is a high 31, and still rising. High risk for sure, but no sell signal just yet.

Another sentiment reading comes from our VIX “Fear Gage” whose lowest reading over the past 5 years has been 11.9, the high over 100. Today’s reading is a low fear 12, hardly an expression of concern. We also have a concern over changes in behavior of mutual fund equity investors, who have been consistent sellers for months. For the past three weeks, behavior has changed and they have become buyers of U.S. equities, to the tune of about $45 billion. Some buying is normal at the start of the year, but not so much.

Stocks are peaking. Our indicators suggest we have not reached a final top, however the leading intermediate indicators are no better than neutral, having declined from strongly bullish. While is too soon to initiate massive sales, we would take advantage of extended prices to trim weaker stocks.