Consider The Bearish Case

5/4/2009


The averages have rallied amid a blizzard of earnings reports, with the Dow Industrials reaching 11-week highs despite the threat of a swine flu pandemic. Choppy near-term trading seems likely, and the primary trend remains in the bearish camp under the Dow Theory. For now, as a partial hedge, we’re keeping 32.5% to 34% of our buy lists in Vanguard Short-Term Investment-Grade ($9.89; VFSTX), a relatively low-risk bond fund.

The bearish case
Looking gift horses in the mouth is part of being a good investor, and whether or not you think stocks are cheap you should consider the primary trend. So, it always makes sense to consider the bearish case. Among today’s best bearish arguments:

The averages have not really shown us much. Despite a 25% rally in seven weeks, all the Dow Industrials have really done is bounce after a big decline, something that happens regularly in bear markets. The Dow Theory will remain in the bearish camp until proved otherwise, which would require two things to occur. First, the market will need to suffer a significant correction without both the Dow Industrials and Dow Transports closing below the respective March 9 lows of 6,547.05 and 2,146.89. Second, both averages will need to move above the closing highs reached in the current rally.

Bear-market rallies are typically a reaction to excessive pessimism rather than genuine improvement in fundamentals, and the rally since March 9 has been led by the down-and-out groups on which investors had been most pessimistic. The S&P 1500 Financial Sector has surged 62%, while the consumer-discretionary sector is up 42%. Among industry groups, homebuilders have rallied 67% and auto-parts makers have jumped 84%. Are investors really discounting better times for homebuilders and auto-parts makers? Were the stocks unduly cheap on March 9? Or did selling such stocks short simply become too popular, leading to a situation where even a glimmer of good news triggered a buying panic? We shall see.

Even beyond industry groups, the rally has been led by companies with the worst fundamentals. Based on Quadrix® scores for Momentum, Quality, Financial Strength, and Earnings Estimates, the bottom one-fifth of stocks in the S&P 1500 Index has handily outperformed the top one-fifth since March 9.

Conclusion
Nearly all big rallies begin with short-covering in beaten-down groups, and it is not unusual for junk stocks to lead in the early stages of a bull market. Still, history suggests the rally will falter unless quality stocks begin to participate more fully.


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