Banks Keep Rally Alive

5/11/2009


Propelled by renewed confidence in the banking sector, the averages have moved to their highest levels in nearly four months. Sentiment and valuation indicators suggest the near-term risk of a market decline has increased, and we’re holding 34% to 35.2% of our recommended equity portfolios in the Vanguard Short-Term Investment-Grade ($9.95; VFSTX) fund.

The Dow Theory today
Because investors look forward — and because the collective wisdom displayed in the action of the Dow Industrials and Dow Transports tends to be better than that of any individual — the Dow Theory has compiled an impressive 100-year record.

But using the Dow Theory is not just a matter of chasing the market’s latest move. In both bull and bear markets, stocks will periodically move counter to the primary trend based on short-term swings in investor sentiment. By monitoring the highs and lows established on such swings, the Dow Theory distinguishes between moves based on short-term sentiment shifts and those based on enduring trends in the outlook for U.S. corporations.

For example, if the Industrials and Transports move below the respective March 9 closing lows of 6,547.05 and 2,146.89 — points reached amid considerable investor angst — it would suggest that the outlook for corporate results is still deteriorating, that even stock prices reached amid March’s panic selling did not fully discount the environment seen now.

Conversely, the closing highs reached in the current rally will represent significant points on the upside. If the market corrects without moves below the March 9 lows in both averages, a rebound that lifts both averages above the highs of the current rally would represent a bull-market signal.

While the Industrials have not quite retraced one-third of the May-to-March decline, the Transports have retraced slightly more than one-third of their June-to-March decline. Considering the extent, duration, and breadth of the rebound, it would be difficult to argue the rally does not qualify as significant.

Sentiment and valuation indicators also suggest the rally since March has been significant. Among investment newsletter monitored by Investors Intelligence, bulls now outnumber bears — something that has occurred only a few times since last summer. The median S&P 1500 Index stock now trades at 15 times expected current-year earnings — up from 11 in March and not far below the norm of 17 since 2004.

Conclusion
With the Dow Theory still in the bearish camp, subscribers should watch the averages, maintain sizable cash positions, and be quick to sell stocks no longer among their favorites.


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