Worrisome Divergence

10/1/2012


Right now there's little doubt regarding the status of the Dow Theory. The question is what you're going to do about it.

Are you going to abandon stocks because of this year's massively divergent performances in the Dow Industrials and Dow Transports? Are you going to stick with stocks because the last confirmed signal under the Dow Theory was the February move to significant highs in both averages? Or are you going to split the difference, maintaining a mostly invested posture while keeping some cash on the sidelines?

For our money, option No. 3 seems about right, as we're keeping 10% to 15% of equity portfolios in a short-term bond fund. We're discouraged by the recent breakdown in the Transports, especially because other economically sensitive groups have also been hit by profit warnings. But making a big move into cash seems premature, for at least three reasons:

The Dow Theory remains in the bullish camp. The weakness in the Transports is worrisome, and a close below the June low of 4,847.73 would add to our concern. But a single average cannot generate a bear-market signal. Just as the Industrials' recent new highs do not change the status of the Dow Theory unless confirmed by a close in the Transports above 5,368.93, a breakdown below 4,847.73 in the Transports would not change much unless confirmed by a move below 12,101.46 in the Industrials.

Nothing says the Dow Theory must be used in an all-or-nothing way to the exclusion of all other considerations. A system needs rules, and the Dow Theory will remain bullish unless the June lows are breached. With the Industrials roughly 10% above the June low, a bear-market signal is unlikely in the very near term. Still, we intend to adjust our portfolios as the news changes and the likelihood of a bull or bear signal changes. The market's reaction to September-quarter results will be crucial.

In addition to the Dow Theory, our stock-market exposure depends on investor sentiment, valuations, and the opportunities available in individual stocks. Among investment newsletters, sentiment has become somewhat exuberant but is not yet at the peak levels reached before corrections in spring 2010 and spring 2011. Sentiment remains unusually pessimistic among Wall Street strategists and mutual-fund investors. Price/earnings ratios suggest stocks are reasonably valued — not cheap but not expensive. One concern is that stocks are expensive relative to historical norms based on price/sales ratios. So, if today's near-record profit margins begin to contract, valuation worries could weigh on stocks. Still, we continue to find well-positioned growers trading at attractive valuations, especially among big stocks. Especially attractive big stocks include Apple ($674; AAPL), DirecTV ($53; DTV), Express Scripts ($63; ESRX), Google ($749; GOOG), and Wells Fargo ($35; WFC).


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