No time to roll the dice

1/5/2009


Stocks headed into 2009 moving mostly sideways, extending a month-long trading range. Near-term action should be watched closely, as a failure to rally in January would be discouraging. With the Dow Theory in the bearish camp, a sizable cash position remains appropriate. Our Focus List and Buy List have 32.5% in Vanguard Short-Term Investment-Grade ($9.68; VFSTX), while our Long-Term Buy List has 34% in this relatively low-risk bond fund.

Gambler’s fallacy
Arguing that another huge market drop is unlikely and it is too late to buy defensive stocks, a money manger in the Dec. 29 Wall Street Journal asked, “What are you going to defend against?”

While that may seem a strange question considering the state of the economy, the quote provides a good example of Wall Street’s version of the gambler’s fallacy. Just as the roulette wheel can always land on black one more time, the market can always extend a losing streak.

Optimists like James Paulsen, chief investment strategist at Wells Capital Management, argue that the stock market typically rebounds sharply after huge declines. The market has suffered declines of at least 40% six times since 1900, Paulsen says, and in five of those instances it recouped 75% of its decline within 18 months of the low.

Such historical examples are worth considering but biased by hindsight, for it is impossible to know whether the rebound from the recent collapse will be measured from Nov. 20 or some later date.

Historically, investors have done well following the Dow Theory, looking for confirmation from the averages before concluding that the market’s primary trend has turned bullish. For the Dow Theory to return to the bullish camp, both the Industrials and Transports will need to reach significant highs.

Significant highs have not been established yet, though moves to at least 9,375 on the Industrials and 3,820 on the Transports would qualify as significant. If the averages reach those levels and pull back without both averages moving below the Nov. 20 closing lows, the stage would be set for a bull-market signal.

Conclusion
Quality stocks are available at attractive valuations, and subscribers should not abandon stocks altogether. But caution remains appropriate, as the averages have yet to demonstrate that a bear-market low was reached Nov. 20. For new buying, top picks include DirecTV ($21; DTV) and Harris ($36; HRS).


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