Testing The Lows

7/30/2012


The stock market has declined in recent trading, as renewed concerns over the euro zone and disappointing quarterly profit and revenue numbers have fueled investor nervousness. 

The Dow Industrials and Dow Transports are now only 4.7% and 1.8% above their respective significant lows of 12,101.46 and 4,847.73. Closes below those levels in both averages would trigger a bear-market signal under the Dow Theory.

To be sure, while the averages test these lows, both the Industrials and Transports also remain relatively close to their recent highs of 13,279.32 and 5,368.93.

The stock market seems nearly equally positioned to excite/disappoint investors, a position that dovetails with evidence supporting the bullish/bearish case for stocks.

The bullish case starts with market resilience:

• Despite quarterly results that have been especially underwhelming in terms of revenue growth and guidance, major indexes have not set new lows.

• Despite continued signs of a slowdown, especially in such important oversea centers as China, indexes have not crumbled.

• Despite new fears about a Spanish bailout, debt downgrades for a host of euro zone countries including Germany, and the ongoing saga that is Greece, stocks have held their lows.

This resilience, coupled with an abundance of attractively valued stocks and lackluster investor sentiment, has bulls betting the lows will hold.

Bears, of course, paint a bleaker picture. They say it is only a matter of time until corporate profits collapse in the wake of flat to lower quarterly revenue, that the illusionists running the Federal Reserve have run out of tricks, that even another round of quantitative easing won’t make a difference, that the collapse of the euro will pollute our shores.

Rather than guess at what might happen, the Forecasts prefers a more pragmatic approach. Under the Dow Theory, the primary trend remains in place until the market’s direction changes demonstrably. The last major signal was bullish. The Dow Theory also holds that the averages discount everything, which is why we must let them tell the tale when it comes to important pivot points.

Conclusion

For now, investors should hold 10% to 15% of equity portfolios in a short-term bond fund. Closes below 12,101.46 in the Industrials and 4,847.73 in the Transports will cause us to reduce our recommended equity exposure initially to 75%. Conversely, a successful test of the lows and rebounds above the significant highs of 13,279.32 in the Industrials and 5,368.93 in the Transports could spur us to increase equity exposure.


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