Real answers to made-up questions

9/22/2008


In 15 years in charge of this newsletter, your editor has learned a few things. And while the ability to read minds is not among them, I’ve heard enough feedback over the years to know what some of you are thinking. So, to provide our take on this unusually volatile market, answers to some of your likely questions are provided below:

Q Your last commentary said “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.” Why isn’t the Dow Theory in the bearish camp already?
A With the Dow Industrials’ recent close below 10,962.54, the risk of a bear-market signal increased. But, under the Dow Theory, one-half of a signal is not necessarily any more indicative than no signal at all. In other words, the Transports must confirm.

Without confirmation, the Dow Theory remains in a state of divergence, with new lows in the Industrials unconfirmed by the Transports. Divergence is a reason to be alert for a trend change, to hold some cash in reserve. Divergence is not a reason to conclude that the primary trend has shifted, even if it is the Industrials reaching new lows. The Dow Theory assigns equal importance to the Industrials and Transports, and the Transports have shown resilience.

Q What should I do with my portfolio? What should I do if the Transports close below 4,653.13?
A To accommodate this week’s downgrade of Oshkosh ($12; NYSE: OSK), I’m lifting the top end of our recommended cash range. Our recommended cash position is now 15% to 25%; of the portion of your portfolio committed to equities, hold 15% to 25% in a money-market or short-term bond fund.

If the Transports close below 4,653.13, our cash position will be 25% to 35% — and our hotline will be updated with specific instructions.

Q That seems like a fairly mild response to a bear-market indication. Considering all the uncertainty impacting the market, does it really make sense to have most of my equity portfolio in stocks?
A Yes, for at least four reasons:

First, I don’t believe in timing the market in an all-or-nothing fashion. Predicting the market’s zigs and zags with precision is nearly impossible, so I tend to err on the side of humility when using the Dow Theory. Our goal is to grow your portfolio over the next five, 10, and 20 years — without taking excessive risk. Holding some cash during adverse market climates is one way we limit risk, but exiting stocks entirely would put a huge premium on precise timing.

Second, the way I see things, 25% to 35% is a lot of cash to hold in an equity portfolio. Stocks tend to deliver positive returns over long periods, and holding 25% to 35% of an equity portfolio in cash is likely to crimp long-term returns substantially.

Third, I see reasons for optimism. Investor sentiment is pessimistic, and the number of shares sold short remains near record levels. The percentage of NYSE stocks trading above their 200-day moving averages, at 24%, is near levels that suggest stocks are due for a bounce. As shown above, stock valuations appear reasonable, especially considering earnings growth outside the financial sector.

Fourth, I like our stocks. Stocks with the best fundamentals (and Quadrix® scores) have underperformed considerably since July, presenting an opportunity to buy bona fide growers at discount valuations. Over the past 15 years, periods like the last two weeks — with investors liquidating stocks en masse — have created buying opportunities in the shares of companies with superior fundamentals and Quadrix scores. As always, our cash position will depend on the primary trend and the opportunities available in individual stocks. If it becomes harder to build a diversified portfolio of stocks I truly like, our cash position will increase.

Q Don’t you read the newspapers? Why are you worrying about the Dow Transports when the nation’s financial sector is imploding?
A The meltdown in the financial sector is bad news. That much is certain. What’s not certain is how much of the bad news is already reflected in stock prices. The fact that the Dow Industrials broke to new lows after the collapse of Lehman Brothers ($0.11; NYSE: LEH) and American International Group ($2; NYSE: AIG) suggests that investors are still adjusting to a worsening environment for stocks, that the share prices reached in the panic selling of July did not fully discount the bad news. With confirmation from the Transports, historically a great barometer for the health of the industrial economy, the market’s verdict would be clear — and raising more cash would be appropriate.

Still, I don’t see today’s problems as the end of American capitalism or a reason to give up on the stock market. Historically, periods of widespread fear have presented opportunities for investors able to keep their heads and use a disciplined system. I expect no different this time around.


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