Waiting For Confirmation

9/17/2012


The Dow Industrials have rallied to the highest level since December 2007, helped by expectations of money-printing from the European and U.S. central banks. While the breakout in the Industrials is encouraging, it does not change the status of the Dow Theory.

Without a close in the Transports above the February high of 5,368.93, uncertainty regarding the business outlook will continue — and the June lows of 12,101.46 in the Industrials and 4,847.73 in the Transports will remain actionable bear-market points.

Still, the last confirmed indication under the Dow Theory was bullish, and it would be a mistake to turn bearish simply because the Transports are trending sideways. Instead, we intend to maintain a mostly invested posture while watching the Transports and other indicators, including:

Cyclical and small-company stocks. Like the Transports, the Morgan Stanley Cyclical Index has strengthened recently but has not surpassed the high reached earlier this year. The Russell 2000 Index of small stocks has rallied within 1% of this year's high and within 3% of an all-time high. Continued strength in such economically sensitive stocks would suggest investors are discounting improvement in the economy — not just migrating toward stocks because the Federal Reserve is suppressing bond yields.

Advance-decline lines. Advance-decline lines limited to S&P 500 and S&P 1500 stocks have moved within striking distance of this year's highs, and near-term strength in the broad market would be bullish.

Foreign stocks. The Fed is worried about a synchronized global slowdown, not just a persistently sluggish U.S. economy. So, strength in overseas stock markets would be encouraging.

The U.S. dollar. Creating money to buy bonds raises inflation expectations and dilutes the value of existing dollars, penalizing investors holding cash. The U.S. dollar has slumped as expectations for Fed action have risen, which could help reported earnings for U.S. multinationals. But a sharp drop in the dollar would be cause for concern, as it would suggest investors are worried that the currency is being debased. In the fiscal year ended September 2011, the Fed bought 77% of all the additional debt issued by the Treasury. If investors begin to fear that such debt monetization is the real motivation behind the Fed's quantitative easing, the money-printing could backfire.

Conclusion

A close in the Transports above 5,368.93 would reconfirm the bullish primary trend under the Dow Theory. Pending such confirmation, we're holding 10% to 15% of equity portfolios in a short-term bond fund.


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