Shrugging off bad news

12/22/2008


Helped by the Federal Reserve’s unprecedented decision to bring short-term interest rates near 0% — and its pledge to use “all available tools” to combat a worsening recession — stocks have advanced despite a steady stream of discouraging economic reports. While encouraging, recent market action has also been consistent with a bear-market rally. 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.

When bad news is not so bad
Among the more bullish things a stock can do is rally on bad news. Such reactions imply that the bad news was already in the stock’s price, that investors are looking ahead to better days. The same holds true for the broad stock market, which has rallied since Nov. 20 amid some truly abysmal headlines.

More than 430 companies have issued negative profit warnings since Nov. 20, while fewer than 70 have delivered positive guidance. Despite those warnings, surging unemployment figures, the potential failure of U.S. auto companies, and a huge fraud at a high-profile money manager, the Dow Industrials have rallied 17% since Nov. 20.

Economically sensitive stocks have paced the rally since Nov. 20, leading some to conclude that investors are beginning to discount an economic recovery. Such a conclusion is premature, for several reasons:

First, the rebounds in the major averages have been modest. As a very general rule, significant rallies retrace one-third to two-thirds of the preceding declines. The Dow Industrials have retraced one-fourth of their May-to-November decline, while the Dow Transports have retraced one-fifth.

Second, cyclical stocks were crushed in the market’s sell-off, so the recent rally may represent nothing more than a dead-cat bounce. The Morgan Stanley Cyclical Index, an equal-weighted index of 30 economically sensitive stocks, dropped 63% from May to November. So, even though the index has rallied 30% since Nov. 20, it has recouped less than one-fifth of its drop.

Third, bear markets typically include significant rallies, and the Dow Theory will remain in the bearish camp until both the Industrials and Transports reach significant highs. So far, significant highs have not been established.

Conclusion
While the market’s recent strength is noteworthy and encouraging, the Dow Theory remains in the bearish camp. Subscribers should maintain a sizable cash position in equity portfolios.


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