July lows gain significance

8/18/2008


The major averages have made choppy but significant progress from the July lows, reflecting decent June-quarter results, lower oil prices, and diminished expectations for inflation. While near-term volatility is likely — and a retest of the July lows would not be surprising — a mostly invested posture seems appropriate. For now, 15% to 20% of equity portfolios should be in a money-market or short-term bond fund.

The state of the Dow Theory
For most investors, the rally since July has not settled much. Surveys of professionals and individuals still reveal widespread pessimism, and major stocks continue to swing widely on headlines.

For Dow Theorists, the rally has cleared things up considerably, as the extent and duration of the rebound suggests the July closing lows of 10,962.54 in the Dow Industrials and 4,653.13 in the Dow Transports represent significant points. With closes below those levels, both averages would be trending lower — and the primary trend would be bearish under the Dow Theory.

Under the Dow Theory, significant lows come at the end of significant corrections. Equivalently, significant lows come at the beginning of significant rallies. In general, significant rallies retrace one-third to two-thirds of the preceding decline over three to 12 weeks.

From highs reached in May and early June, the Industrials and Transports suffered significant declines, slumping more than 15%. From the July lows to Aug. 11, the Industrials gained more than 800 points, retracing nearly two-fifths of the May-to-July decline. The Transports gained more than 550 points, retracing two-thirds of the June-to-July decline.

Key points to watch
If the Industrials close above 13,058.20 and the Transports close above 5,492.95, the bullish primary trend would be reconfirmed. With closes below 10,962.54 and 4,653.13, the primary trend would be bearish. Without a move below 10,962.54 in the Industrials, a close below the March low of 4,398.97 in the Transports would be problematic for Dow Theorists — though there is no doubt that this unlikely scenario would be discouraging.

As always, our cash position will depend on the primary trend and the values available in individual stocks. A bearish indication under the Dow Theory would be a reason to raise our cash position. But we are unlikely to exit the market entirely, partly because of the availability of reasonably valued stocks with operating momentum and solid growth outlooks. Two such picks with standout year-ahead potential include Accenture ($41; NYSE: ACN) and Harris ($51; NYSE: HRS).


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