2 Funds to Buy While the Market Decides

06/20/2011 11:30 am EST

Focus: FUNDS

Richard Moroney

Editor, Dow Theory Forecasts

While indecision reigns supreme, it's a good time to find solid bargains that are diversified and safe, says Richard Moroney of Dow Theory Forecasts.

While most economists appear confident that the current “soft patch” in the US economy will give way to decent growth, investors are not so sure about US stocks.

Surveys of individual investors, advisors, and money managers reveal a sharp decline in bullishness over the past six weeks. US equity funds have seen a surge in outflows since early May.

With investors running scared, the risk of a more substantial near-term correction should not be discounted. A typical secondary correction retraces one-third to two-thirds of the preceding advance, and the Dow Industrials and Dow Transports have retraced only one-third of their rallies from the August lows.

Two-thirds corrections would put the Industrials at 10,925 and the Transports at 4,565. Such a decline would put the market’s valuation at fairly modest levels, unless the outlook for corporate profits deteriorates considerably.

Indeed, with the S&P 500 Index trading at 13 times expected 2011 earnings, and yields on ten-year Treasury bonds near 3%, many argue that stocks are already comparatively cheap. The median S&P 500 stock trades at 16 times trailing earnings, lower than nearly 80% of the month-end observations since January 1992.

Clearly, investors are skeptical of consensus profit forecasts, which call for at least 14% year-to-year profit growth for the S&P 500 Index in each of the next three quarters. In 2012, the consensus projects a 13% increase, with all ten sectors except health care and utilities expected to post double-digit growth.

While we tend to side with the optimists on profits, skeptics see valid reasons for concern around the globe.

While the global outlook is murkier than usual, stocks are seldom attractively priced when everything looks rosy. Moreover, the last significant development under the Dow Theory was the move to new highs in the Dow Industrials and Dow Transports this spring.

A move to new highs above 12,810.54 in the Industrials and 5,527.50 in the Transports would reconfirm the bullish trend. If the market rallies meaningfully (but fails to reach new highs in both averages), then slumps below the closing lows reached in the current correction, the Dow Theory would shift into the bearish camp.

For now, we’re maintaining a mostly invested equity portfolio, while monitoring the averages and the outlook for corporate profits.

As a partial hedge, try Vanguard Short-Term Investment-Grade (VFSTX). Also, Vanguard Dividend Growth (VDIGX) offers a top choice.

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