Beware of false dichotomies

5/5/2008


The Dow Industrials are trading at three-month highs, while the Dow Transports have moved within 6% of the all-time high reached in July. With the primary trend in the bullish camp under the Dow Theory, a constructive stance toward equities is appropriate. The Vanguard Short-Term Investment-Grade ($10.56; VFSTX) fund now represents 16% of our Buy List and 15% of our Long-Term Buy List.

Whistling past the graveyard?
When two market indicators that usually move together go in separate directions, analysts call it divergence. Such divergence suggests that the outlook is uncertain, that investors should be wary of attaching too much importance to the direction of either indicator.

For Dow Theorists, divergence between the Dow Industrials and Dow Transports was resolved in April, when the Industrials confirmed an earlier move to significant highs in the Transports. Some analysts view the S&P 500 Index’s recent close above its Feb. 1 closing high of 1,395.42 as notable, as it resolved divergence between the S&P 500 and the Dow Industrials.

Among some bears, however, recent market action has done nothing to resolve today’s greatest divergence: the difference between the past year’s massive dislocation in the credit markets and the relatively short and shallow bear market in stocks.

As more than a few commentators have asked, how can the stock market avoid even a 20% decline amid one of the all-time worst periods for the housing and credit markets? While this question seems reasonable, it is based on a false dichotomy. Consider the following:

  • Pain from the housing and credit-market collapses has been concentrated in sectors tied to finance and consumer spending. The finance and consumer-discretionary sectors suffered declines exceeding 27% from peaks reached in early June, so it is difficult to argue that equity investors are blithely ignoring the economic fallout.
  • The sectors leading the market’s recovery — energy, industrials, materials, and technology — are benefiting from continued growth in the global economy, which has become less dependent on the U.S. So far, U.S. corporate earnings growth outside the financial and consumer sectors has held up well.
  • Many of the credit market’s problems reflect overly complicated and opaque structures for fixed-income investments, especially those tied to mortgages. Plain-vanilla corporate bonds, even junk bonds, have registered gains over the past year. Relative to corporate-bond yields, stocks are quite cheap versus historical norms.

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