Bullish Trend Reconfirmed

9/23/2013


The Dow Industrials and Dow Transports rebounded above the all-time highs reached in early August, reconfirming the bullish primary trend. With the Dow Theory squarely in the bullish camp, subscribers should maintain a nearly fully invested posture while looking for opportunities on a stock-by-stock basis. For now, our buy lists have 94% to 98% in stocks, with the rest in a short-term bond fund.

Bond yields versus earnings yields

Bond yields dropped sharply Sept. 18 after the Federal Reserve, which had spent months preparing investors for a cutback in its $85-billion-a-month in bond purchases, said it would keep the program in place for now. Continued downward or even sideways movement in bond yields would be a big positive for stocks, as price/earnings ratios suggest stocks remain quite cheap versus bond yields.

As shown in the table below, the earnings yield (earnings/price ratio) on the S&P 500 Index is about 5.3% using as-reported trailing earnings. That compares unfavorably to the 35-year norm of 6.3%, according to data from Robert Shiller at Yale University. But the S&P 500's earnings yield is 2.6% higher than the yield on 10-year Treasury bonds — well above the 35-year norm. In fact, the spread is higher than about 87% of the months since 1978.

S&P 500 VS. 10-YR. TREASURY YIELDS
S&P 500
Earnings
Yield *
(E/P Ratio)
(%)
S&P
500
Div.
Yield
(%)
10-Year
T-Bond
Yield
(%)
Earnings
Yield
Minus
T-Bond
Yield
(%)
Div.
Yield
Minus
T-Bond
Yield
(%)
Recent
5.3
2.1
2.7
2.6
(0.6)
Norm since Jan. 1946
7.1
3.5
5.8
1.4
(2.3)
Norm since Sept. 1963
6.6
3.0
6.7
(0.1)
(3.7)
Norm since Sept. 1978
6.3
2.8
6.9
(0.6)
(4.1)
% of months lower since Jan. 1946
27.7
20.6
14.5
71.3
75.4
% of months lower since Sept. 1963
33.6
28.0
4.0
86.3
95.4
% of months lower since Sept. 1978
45.1
40.2
5.8
87.2
93.4
* Based on as-reported trailing 12-month earnings.

The 10-year Treasury yield has surged to 2.7% from about 1.9% on May 21, the day before Federal Reserve Chairman Ben Bernanke told Congress that the central bank could "step down" its bond-buying program with sustained improvement in the job market. With the Fed now delaying any cutback in its bond purchases, saying it wanted "more evidence that progress will be sustained before adjusting the pace of purchases," equity investors will be following the bond market especially closely.

If bond yields rise gradually as economic revival increases the competition for money, stocks should do fine. If bond yields surge because investors conclude yields can no longer be suppressed artificially by the Fed's bond-buying program, stocks will be swimming upstream. Still, stocks are likely to compare favorably with bonds for some time. All else equal, it would take a move to 5.9% on the 10-year Treasury yield to bring its relationship with the S&P 500's earnings yield to the 35-year norm.

Conclusion

With both the Industrials and Transports reaching all-time highs, the market's primary trend is unequivocally bullish. Subscribers should maintain a nearly fully invested posture, looking for attractively valued growers. Capital One Financial ($69; COF) and Dover ($90; DOV) represent top picks.


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