Raise Some Cash
The Dow Theory is designed to identify big shifts in the stock market's direction. After several years of a bull market, these shifts are detected much the same way a person on the seashore might try to determine if the tide is still coming in â€” by placing a marker in the sand at the highest point the waves have reached.
If that marker is surpassed, chances are the tide is still coming in. When the biggest waves no longer reach the marker, you can usually be sure the tide has turned, especially when the high points of small waves are lower than any seen recently.
For Dow Theorists today, the high points on the beach are not in question. If the December all-time closing highs of 18,053.71 on the Dow Industrials and 9,217.44 on the Dow Transports are surpassed, the bullish primary trend would be confirmed.
Both are within 4% of those highs, so it may seem premature to draw any conclusions regarding a turn in the market's tide. But both averages have struggled to make headway despite mostly good news on the U.S. economy, the introduction of money-printing in Europe, and big drops in energy costs and interest rates. If the averages can't make new highs in that environment, when will they?
On the downside, the question for Dow Theorists is whether the closing lows reached Jan. 15 â€” 17,320.71 on the Industrials and 8,655.94 on the Transports â€” represent significant points. There is no doubt the corrections to those points qualify as meaningful; what's in doubt is whether the averages rallied enough from the Jan. 15 lows to establish those points as significant.
The Transports rallied 5.6% from Jan. 15 to Jan. 22, while the Industrials gained 2.8%. While rallies or declines of less than 3% are generally not regarded as significant under the Dow Theory, the averages' inability to hold the Jan. 15 lows must be viewed as discouraging.
Risk on the rise
When underlying company values are rising, either because of lower bond yields or rising earnings and dividends, stocks will tend to make new highs. Sometimes stocks will outrun fair value when investor sentiment is unusually optimistic. But, in a bull market, those sentiment-driven highs will be surpassed because underlying values are rising.
Conversely, when the averages break below previous low points that were reached in a period of investor gloom, underlying values are probably deteriorating.
Both the Industrials and Transports closed below the Jan. 15 lows on Jan. 30. Does that signal the start of a bear market? Not definitively, but it means the risk of a bear market has risen, especially considering the failed attempts at new highs since December.
Encouragingly, the broad S&P 500 and Wilshire 5000 indexes have managed to avoid breakdowns below their Jan. 15 closing lows. Advance-decline lines for the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes have also avoided new lows.
A breakdown to new lows in the broad market would be a reason to get more defensive. For now, as a precaution, we are raising some cash in our buy lists, lowering their equity exposure to about 85%. We're also making some changes in our recommended fund portfolios to reduce their stock-market exposure.
While we are taking a more defensive posture, we continue to look for buying and selling opportunities on a stock-by-stock basis. Top picks include Ameriprise ($132; AMP), Lear ($109; LEA), and Foot Locker ($54; FL).