Stumbling To The Finish Line

12/31/2012


The market's year-end rally has lost some vigor. With trading typically herky-jerky this time of year as a result of tax selling, portfolio window dressing, and lower holiday trading volumes, fiscal-cliff concerns add to what is already a potentially volatile mix. Still, with the market's primary trend bullish under the Dow Theory, investors should maintain the bullish exposure that has paid dividends this year.  

New highs important

The market has pulled back a bit in recent trading, as investors weigh the implications of "going over the cliff." Another factor being considered by the market is the future of corporate profits. Fourth-quarter earnings season begins in only a few weeks. And while all earnings seasons are important, this one carries special weight.

Corporate profits started to show some strain in the third quarter, and analysts have been marking down expectations for fourth-quarter profit growth. Less than three months ago, Wall Street expected nearly 10% earnings growth in the quarter. Today, analysts expect less than 3% growth.

Whether the trend remains bullish depends in large part on the market's ability to surpass previous important highs. Currently, the Dow Industrials are less than 4% from their October high of 13,610.15. The Dow Transports are less than 2% from their February high of 5,368.93. The fact that both Dow averages have approached key highs is good news in the short run. But history shows that when markets come very close to important highs yet fail to close above them, stocks usually succumb to sharp pullbacks.

Bottom line: While the fiscal cliff continues to get the attention, the factor that should have the most say on whether the bull market continues is corporate profits. New closing highs in the Dow Industrials and Transports would validate the positive earnings story. Failed attempts at new highs by one or both of the averages would signal trouble on the earnings front, probably foreshadowing a market decline.

Conclusion

As usual, investors facing lots of noise and crosswinds should listen to the averages. New highs in the Dow Industrials and Transports above 13,610.15 and 5,368.93 would reconfirm the bullish trend and provide an "all-clear" sign for investors. On the other hand, the failure of the Industrials and Transports to close at new highs would be a negative for stocks, while closes below 12,542.38 in the Industrials and 4,891.27 in the Transports would trigger a bear-market signal under the Dow Theory. For now, as a partial hedge, investors should hold about 9% to 11% of equity portfolios in a short-term bond fund


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