Bargain-hunting buoys stocks

12/8/2008


Trading remains incredibly volatile, with bargain-hunting and downbeat earnings news pushing stocks in opposite directions. The averages’ ability to hold above the Nov. 20 closing lows — 7,552.29 on the Dow Industrials and 2,988.99 on the Dow Transports — will be watched closely.

With the primary trend in the bearish camp under the Dow Theory, holding a sizable cash position seems prudent. Our Focus List and Buy List have 32.5% in Vanguard Short-Term Investment-Grade ($9.61; VFSTX), while our Long-Term Buy List has 34% in this relatively low-risk bond fund.

Determining the trend
The main purpose of the Dow Theory is to determine the direction of the primary trend — the broad swing in stock prices that generally lasts 12 months or longer. When both the Industrials and Transports reach significant lows, as they did in November, the primary trend is presumed to be bearish.

No significant highs have been established at this point, though continued near-term strength could qualify the highs of the current rally as significant. In general, significant rallies retrace at least one-third of the preceding decline, meaning rebounds to at least 9,375 on the Industrials and 3,820 on the Transports would qualify.

If both averages reach those levels, two things would be required for a bull-market signal. First, the market would need to correct with at least one average holding above its Nov. 20 low. Second, both averages would need to close above the highs established in the current rally.

While much needs to occur for a bull-market signal, we see several reasons to maintain exposure to stocks:

• First, the stock market is cheap. While there is much debate about whether stocks are truly cheap given today’s gloomy outlook, stocks around the world are cheap relative to historical norms based on earnings, normalized earnings, book value, and cash flow.

• Second, many quality stocks are truly cheap. Among the 25 stocks on our Buy List, 15 trade at less than 10 times this year’s expected earnings.

• Third, sentiment is pessimistic. Based on the advice of investment newsletters, the cash positions of hedge funds, and the pricing of options, sentiment has rarely been as pessimistic.

• Fourth, stocks are oversold. Based on the percentage of NYSE stocks trading above 200-day moving averages, now 3%, stocks have seldom been so oversold.

• Fifth, a bear-market rally could be substantial. With a typical one-third to two-thirds retracement of the May-to-November decline, the Industrials would trade at 9,375 to 11,200.


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