Averages hit Resistance

2/20/2012


With the average stock in the S&P 500 Index up more than 20% over the past six months, now seems a good time to revisit the key factors that drive our stock-market exposure:

The Dow Theory. Rallies in the Dow Transports and S&P 500 above their 2011 highs would be encouraging, but the primary trend will be viewed as bullish unless three things happen. First, the Dow Industrials and Transports need to suffer significant corrections. Second, on the subsequent rebound one or both averages must fail to surpass the closing highs reached prior to the corrections. Third, both averages need to move below their correction lows.

As a rule of thumb, significant corrections retrace one-third to two-thirds of the preceding advance over three to 12 weeks. For the Industrials, a one-third retracement of the October-to-February advance would mean a drop to 12,145, while a two-thirds retracement would put the Industrials at 11,400. For the Transports, the equivalent range is 4,925 to 4,480. In other words, declines from recent highs of as much as 12% in the Industrials and 17% in the Transports would be consistent with a typical secondary correction.

Valuations. Relative to bond yields, stocks are very cheap. But just because the Federal Reserve is suppressing interest rates does not qualify stocks as a bargain. Relative to historical norms, the average large-company stock is still somewhat cheap. As shown on the lower right, the average midcap and small-cap stock now trades roughly in line with 17-year norms based on price/earnings and other valuation ratios.

Sentiment. When investors become unusually optimistic, it often signals that stocks are due for a pullback. Recent sentiment indicators reveal widespread optimism, with surveys of institutional investors, newsletter editors, and individuals showing bullishness above historical norms. According to Investors Intelligence, the percentage of bullish newsletters is above 54% for the first time since April, right before the market slumped on worries regarding Europe and a potential U.S. recession.

Intermediate potential risk. The percentage of New York Stock Exchange stocks trading above their 200-day moving average is up to 74%. Historically, a percentage above 70% has signaled an elevated risk of a market correction.

Conclusion

A near-term decline to 12,145 to 11,400 on the Dow Industrials would not be surprising. But we are inclined to view such a decline as a buying opportunity because of the bullish status of the Dow Theory, the reasonable valuations of U.S. stocks, the modest yields in the bond market, and the availability of attractively valued growers like Aetna ($47; AET).


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