For Now, Stay The Course

8/11/2014


Stocks have slumped, with the Dow Industrials and Dow Transports suffering significant corrections from the July highs. For now, we are inclined to view the weakness as a bull-market correction. Our buy lists have 91% to 97% in stocks.

Status of the Dow Theory

With the market expensive but not outrageously valued — and stocks recently failing to rally on seemingly good earnings and economic news — the Dow Theory is likely to be the key driver in our asset allocation in the near term.

Under the Dow Theory, the last major signal from the averages is presumed intact until proved otherwise. The last such signal came in July, when all-time highs in the Industrials and Transports reconfirmed the bullish primary trend.

For a bear-market signal under the Dow Theory, three things must happen. First, the averages need to suffer significant corrections. Second, the market needs to rebound without new highs in both averages. Third, both averages need to close below the closing lows reached in the corrections.

As a very rough guideline, significant corrections retrace one-third to two-thirds of the preceding advance. Both averages have met those parameters. The Industrials have retraced more than 60% of their April-to-July advance, while the Transports have retraced more than 35%.

If the averages rebound to new highs with closes above 17,138.20 in the Industrials and 8,468.54 in the Transports, the bull market will be reconfirmed and the low points reached in the current correction will no longer be relevant. But if the averages rally without both reaching new highs, the lows of the current correction will be actionable bear-market points.

While stocks typically don't move in straight lines, there is no guarantee that the averages will rally before a move below the April lows. A breakdown below the April lows would be a negative development — and perhaps a reason to raise some cash — but it would not represent a bear-market signal.

Sentiment and plan of action

The Dow Theory is not designed for rapid-fire signal changes, but nothing says the Dow Theory must be used to the exclusion of all other considerations. For our money, we'd be more inclined to stay nearly fully invested if investor sentiment deteriorates considerably. The percentage of bullish investment newsletters, though down from a multiyear high in June, still does not point to widespread caution among investors, according to Investors Intelligence. Bullishness among Wall Street strategists has dropped to a 13-month low but remains well above the lows reached in 2012, according to Bank of America Merrill Lynch.


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