Averages At An Impasse

10/14/2013


After reaching all-time highs Sept. 18, when the Federal Reserve said it would not scale back its bond-buying program, the Dow Industrials fell on 11 of the next 14 trading days. While the Dow Industrials' 6% pullback since Sept. 18 exceeds those of the Dow Transports and S&P 500 Index, all three indexes have seen steady selling pressure — even though bond yields have reacted as the Fed presumably wanted.

Yields on 10-year Treasury bonds have dropped below 2.65%, down from 2.85% on Sept. 17. Mortgage rates have also dropped, helping spark a bounce in refinancing demand. Yet banking- and housing-related stocks have slumped along with nearly everything else, with the financial sector now trading near three-month lows. The Russell 2000 and other small-company indexes, after edging to marginal new highs on Oct. 1, have joined the downturn.

Dow Theorists attach considerable importance to new highs, and the Sept. 18 all-time highs in the Industrials and Transports represented an unambiguous reconfirmation of the bullish primary trend. But the one-way action since Sept. 18 has caused many to question the validity of the signal. Isn't it possible, some ask, that the new highs were a false breakout?

It certainly is. The Dow Theory is premised on the idea that the majority money opinion is usually — not always — correct. After all, the Dow Theory is typically bullish at market peaks and bearish at market lows. The more relevant question is whether recent action justifies a move to a more defensive posture. At this point we think the answer is no, for at least four reasons:

• First, market pullbacks after confirmed new highs are not unusual. The push to new highs often exhausts investors' buying capacity on a near-term basis, leaving stocks vulnerable to a setback.

• Second, uncertainty related to the government shutdown and debt-ceiling impasse is partly to blame for the pullback. The debt battle could cause lasting damage if America's creditworthiness truly comes into question, and it's impossible to know how much of the recent stock-market damage would be reversed with a budget deal. But the impasse has already resulted in sharply lower consumer confidence and sharply higher yields on some Treasury bills, so a deal could trigger a meaningful relief rally.

• Third, sentiment does not seem indicative of a market top. Surveys suggest bullishness among individuals, newsletters, and Wall Street strategists is below or in line with historical norms.

• Fourth, we're still finding stocks with year-ahead and long-term return prospects superior to what's available in the bond market. For now, our buy lists have 94% to 98% in stocks. Especially promising names include Capital One Financial ($68; COF) and Qualcomm ($66; QCOM).


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