New Highs Within Striking Distance
The Dow Theory is premised on the idea that investors, collectively, usually get things right. That does not mean the stock market can't trade at a discount or premium to fair value. But fair value and share prices generally trend in the same direction, with share prices moving first because investors look forward. By determining the market's primary trend you can learn the majority money opinion — and history suggests that is one opinion worth considering as you plot strategy for 2013.
Sometimes the primary trend can be discerned with a glance at the charts of the major averages, like when both the Dow Industrials and Dow Transports are at all-time highs or multiyear lows. But share prices are more volatile than fair value, partly because investors are vulnerable to swings of optimism and pessimism. For that reason, discerning the market's underlying long-term trend is not always easy.
To help distinguish the short-term zigs and zags triggered by sentiment swings from more enduring trend changes, adherents of the Dow Theory focus on significant highs and significant lows. For example, when the Industrials closed at 13,610.15 on Oct. 5, a nearly five-year high, investor bullishness was at a short-term peak. A rebound above 13,610.15 would suggest that underlying company values are rising, since it would mean the majority money opinion views stocks as attractive — even at prices higher than those that accompanied a prior spike in bullish sentiment.
To guard against false signals, Dow Theorists insist that both the Industrials and Transports must reach significant highs or significant lows for a valid indication. In our view, a breakout above this year's respective highs of 13,610.15 and 5,368.93 would reconfirm the bullish primary trend under the Dow Theory. A breakdown below the respective November lows of 12,542.38 and 4,891.27 would suggest the primary trend is bearish.
Our game plan for 2013
Stocks appear reasonably valued based on price/earnings and other valuation ratios, but the outlook for profits is cloudy. We're emphasizing shares of companies likely to grow profits even if consensus profit expectations for the S&P 500 Index are headed lower. And we are maintaining a mostly invested posture, holding about 9% to 11% of our equity portfolios in a short-term bond fund, as we watch the averages.
Our bond-fund position will be increased to at least 25% with a bear-market signal, while a bull-market confirmation would trigger a cut to 5% or lower. A bull-market confirmation is likely to trigger a run at the all-time highs of 14,164.53 in the Industrials and 5,618.25 in the Transports, and a move above those levels would make it impossible to conclude the trend is anything but bullish.