The Averages Discount Everything
Underlying the Dow Theory is the idea that investors, collectively, usually get it right. When the price of a stock is going up, chances are its underlying value is also going up. At any given time investors will be overly optimistic on some companies and overly pessimistic on others. But such differences tend to even out when averaged over enough companies, so there's much to be gained from knowing whether the average stock is trending higher or lower.
If that all sounds reasonable enough, you next need to ask yourself two questions. How should you measure the average stock? And how do you know if it is trending up or down?
Dow Theorists focus exclusively on the Dow Industrials and Dow Transports, reasoning that shares of widely followed industry leaders are the best barometer of the majority money opinion. When both the Industrials and Transports are reaching significant highs, the primary trend is presumed bullish. When both are hitting significant lows, the trend is bearish. In our view, this year's highs of 13,279.32 and 5,368.93 are significant, as are the June 4 closing lows of 12,101.46 and 4,847.73.
While the state of the Dow Theory is clear, other market averages can provide additional insight:
• The S&P 500 Index of big U.S. stocks and Wilshire 5000 Index of all U.S. stocks. These indexes, weighted by stock-market value, are closely watched benchmarks for institutional investors. Both indexes are trading about 6% below this year's highs and 10% to 15% below all-time highs reached in 2007.
• The Morgan Stanley Cyclical Index, the Russell 2000 Index of small stocks, and economically sensitive sectors. The demand for shares of big, defensive blue chips is not the stock market's biggest problem. Seven of the 30 stocks in the Dow Industrials have reached all-time highs this year, and two more are close. But cyclical stocks and small stocks peaked in March. Improvement outside today's favored "safe" stocks would bode well for the market.
• Advance-decline lines and equal-weighted indexes. A rally carries more weight when supported by the broad market. Encouragingly, the NYSE advance-decline line, a running total of advancing minus declining stocks, is near all-time highs.
• Apple ($608; AAPL). A sustained rally requires leadership. If the most valuable U.S. company posts another blowout earnings report but the stock fails to surpass its high of $644, near-term market prospects would suffer.
For now, we intend to hold 10% to 15% of equity portfolios in a short-term bond fund as we watch the averages. For new buying, McKesson ($93; MCK) offers a top pick.