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Signs of a Bottom

03/25/2008 12:00 am EST


Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, says many of the good blue chip stocks he follows have fallen to where they’re starting to look attractive.

Growing up in a family of contractors, I learned a lot about structural integrity and the dangers associated with short-term fixes. When structural irregularities are observed in a foundation, a competent contractor will stop all vertical construction, prop up the foundation, identify the source of the irregularity, fix it, make sure the fix is sound, and then resume vertical construction. If a foundation is irreparable then the site is probably no good and the engineer has some explaining to do; thus the existence of bonding and insurance.

The above is an analogy for current market conditions. In the previous bull market, valuations on the Standard & Poor’s 500 reached what Dr. John Hussman of the Hussman Funds terms as a “psychotic” 34x record earnings. Hussman states further that “as a result, the 2002 bear market trough occurred at the highest valuation (15x record earnings) of any prior bear market trough in history, and failed to clear the excesses of the prior bubble.”

Structurally, then, the bull move that began in October/November 2002 was foundationally unsound. It can be argued that a combination of fiscal and monetary policies was adopted as a “short-term fix,” but the requisite work to cure the structural irregularities for the long term was never completed. This explains in part why at the 2002 lows our undervalued category consisted of a paltry 16% of our select blue chips, as opposed to the historical norm of over 50%.

The number of select blue chips is significantly smaller today than in November 2002; 297 versus 346. [Early this month] the Undervalued category represented approximately 27% of the select blue chip universe. Interestingly, the dividend yield for the Dow Jones Industrial Average [in] November 2002 was 2.40%. As I write, the dividend yield on the Dow is 2.63%.

A smaller universe of stocks with a higher percentage of undervalued and an increasing dividend yield on the Dow suggests to me that that value, good historic value anyway, is drawing close.

Historically, the high-yield area for the Dow is 3.0%. Based on the current cash dividend of $313.47, a dividend yield of 3.0% would be reached at Dow 10,449. A decline to that level would be, in my view, extreme. The upper range of undervaluation on the Dow (10% above 10,449) would equal Dow 11,494—not out of the question considering the intra-day low on January 22nd was 11,634.82.

The primary focus for investors should be the market of stocks that represent high-quality and good value, not the stock market. In that vein many of our select blue chips already represent good historic value. I would suggest that waiting for an “all clear signal” at the eventual market bottom will, in hindsight, represent missed opportunity.

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