Correction Overdue

2/25/2013


Charles Dow described the stock market as having three trends: primary bull and bear markets that can endure for several months to several years; secondary reactions that tend to span a few weeks to a few months; and daily ups and downs that reflect news and the related vagaries of buying and selling.

The Dow Theory, which owes much to Dow's editorials in The Wall Street Journal between 1899 and 1902, is best at identifying primary bull and bear markets. When both the Dow Industrials and Dow Transports are reaching significant highs (or lows), the primary trend is bullish (or bearish). Following this simple rule has been highly rewarding over the last 100-plus years, and since 1946 Dow Theory Forecasts has recommended that investors focus mostly on the primary trend when setting stock-market exposure.

Still, secondary reactions are hugely important, for it is the penetration of the endpoints of previous secondary reactions that signals a change in the primary trend. Corrections in mature bull markets can be nerve-racking, for every change in the primary trend begins with a reaction against the prevailing trend.

A typical secondary correction retraces one-third to two-thirds of the preceding advance over three to 12 weeks, but history suggests that even those broad parameters should be viewed as rough guidelines. For the Industrials, a one-third to two-thirds retracement of the advance since mid-November would bring a decline to about 13,525 to 13,035. For the Transports, such a retracement would put the average at 5,600 to 5,240.

The market has now gone 15 months without a 10% correction and more than three months without a 5% correction — both unusually long winning streaks. More than 80% of New York Stock Exchange stocks are trading above their 200-day moving average — a percentage higher than 90% of the daily observations since January 1989 and a level associated with a higher-than-normal risk of a correction.

The percentage of bullish investment newsletters exceeds the percentage bearish by more than 26% — down from nearly 34% in early February but still at a level that often presages a market pullback, according to Investors Intelligence. Surveys of individuals also reveal fairly widespread optimism, and option prices suggest traders are complacent.

Conclusion

The primary trend is bullish. Secondary corrections are difficult to time with any precision — and with valuations still reasonable we are not prepared to raise cash aggressively at this point — but subscribers should not be surprised by a market pullback. For now, our Buy List and Focus List have 97.5% in stocks, versus 91.9% for our Long-Term Buy List. CVS Caremark ($53; CVS) represents a top pick for new buying.


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