Cyclicals under pressure
The U.S. Treasury’s takeover of mortgage giants Fannie Mae and Freddie Mac failed to calm the stock market. Continued volatility seems likely, and a breakdown below the July lows of 10,962.54 in the Dow Industrials and 4,653.13 in the Dow Transports would put the Dow Theory in the bearish camp. For now, subscribers should hold 15% to 20% of equity portfolios in short-term reserves.
Underlying the Dow Theory is the idea that the stock market usually gets things right. Because the collective wisdom of market participants tends to be more accurate than the vast majority of investors, you can improve your chances by considering the primary trend when positioning your portfolio.
Some argue that the Dow Theory’s reliance on the Industrials and Transports is outdated, that focusing on the major averages is a mistake because so much of the market’s action reflects industry-group rotation. This argument has some merit, as focusing only on the averages can lead to missed opportunities.
In addition to the market’s primary trend, our cash position depends on the opportunities available in individual stocks. If many industry groups have favorable valuations along with operating and share-price momentum, attractive opportunities in individual stocks will tend to be plentiful. Moreover, industry-group action can shed light on investors’ expectations.
Group action since July points to weakening expectations for the economy. Such economically sensitive sectors as energy, materials, and technology have faced heavy selling, while defensive areas like consumer staples and health care have held up well. Investors’ flight to safety explains some of the strength in defensive groups. But these groups have also benefited from sharp declines in interest rates and inflation expectations, which tend to raise the present value of companies with steady earnings.
Will the strength in defensive groups be enough to counter expectations of a slowing economy? Only time can answer this question. But we are skeptical, partly because stocks with the best fundamentals (and Quadrix® scores) have vastly underperformed stocks with the worst fundamentals since July. Historically, such “worst-is-best” periods have proved fleeting.
Continued weakness in economically sensitive groups would be bearish, as the fundamentals of many defensive groups seem incapable of sustaining extended upturns. The selling in several energy and materials stocks seems overdone, and Freeport-McMoran ($69; NYSE: FCX) and Transocean ($115; NYSE: RIG) offer attractive values.