Stocks Feel The Heat

2/3/2014


U.S. stocks have been hit with their first serious selling pressure since early October, with sell-offs in emerging markets adding to worries regarding the outlook for corporate profits. December-quarter results have been solid; the percentage of companies beating earnings and sales expectations is up from recent quarters. But the reports have included some notable warnings, and profit-growth expectations for the March quarter and full-year 2014 have eroded since earnings season began. While we think the decline is likely a correction in an ongoing bull market, the sharpness of the drop has raised some questions for Dow Theorists:

How much further could the correction go? The Dow Theory cannot forecast the duration or severity of market moves, and timing secondary corrections with precision is very difficult for any type of trader. The Dow Industrials have not suffered a 10% correction since 2011, and it would not require a huge change in the investment climate to trigger such a move. All that's needed is a temporary loss of nerve.

Does the recent correction qualify as significant under the Dow Theory? According to classic Dow Theory, a significant secondary correction retraces one-third to two-thirds of the preceding advance over three to 12 weeks. Those parameters were always more of a guideline than a definition, and corrections seem to occur more quickly nowadays.

Still, a one-third to two-thirds retracement of the October-to-December advance in the Dow Industrials would put the average at 15,977 to 15,377. For the Dow Transports, the comparable range is 7,196 to 6,821. That means the Industrials have already met all the parameters of a typical secondary correction. The Transports closed below 7,196 on Jan. 29, just four trading days after closing at an all-time high.

All things considered — including a two-week correction in the S&P 500 Index that has retraced 39% of its October-to-January advance — we're inclined to view the recent pullback as significant. If the Industrials and Transports rebound above their respective all-time highs of 16,576.66 and 7,569.89, the bull market will be reconfirmed. But if the averages rebound without both reaching new highs, the closing lows reached in the current pullback will represent bear-market points.

What should I do now? For now, our advice is largely unchanged: (1) watch the averages; (2) maintain a mostly invested posture; and (3) look for opportunities on a stock-by-stock basis, emphasizing attractively valued shares of high-quality growers. Don't be afraid to buy reasonably valued stocks that rally on better-than-expected quarterly reports, and don't be afraid to sell stocks that slump on disappointing results.

Holding some extra ready cash on the sidelines is not a bad idea. If you think you will need a little more cash than the 4.8% to 7.4% on our buy lists to weather a storm, raise it now. But don't move to the sidelines, and don't stop looking for buying opportunities. Among Forecasts recommendations that posted solid December-quarter results, especially promising names include Comcast ($53; CMCSa), United Rentals ($82; URI), and Wells Fargo ($46; WFC).


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