Bad News Tests Rally

5/18/2009


The averages have dipped after an impressive nine-week rally, with the Dow Transports retreating nearly 12% from the recent high. With the Dow Theory in the bearish camp, we’re holding about 31% to 33% of our equity portfolios in Vanguard Short-Term Investment-Grade ($10.02; VFSTX), a relatively low-risk bond fund.

Wall of worry
For some investors, nothing is more bullish than a stock market advancing amid seemingly bad news. If stocks rally despite discouraging news, it suggests that the news was already reflected in share prices — or that investors are already looking past the near-term gloom to a brighter tomorrow.

At some point, however, the news needs to turn for the better to sustain a bull market. Otherwise, the divergence between today’s gloom and expectations of tomorrow’s boom grows too wide — and investors sell shares rather than stake too much on a recovery.

For example, the S&P 500 Index now trades at nearly 15 times expected year-ahead earnings, up from less than 10, because of higher stock prices and lower profit estimates. Valuation indicators based on individual stocks tell a similar story: Stocks trade only modestly below historical norms.

Unless earnings estimates begin to improve, investors will need to pay premium valuations or the rally will falter. A rising price/earnings ratio is typical in the early stages of a bull market, and the P/E could climb considerably if investors’ confidence in the long-term outlook improves. Still, a rising P/E will intensify investors’ thirst for concrete signs of recovery.

The Dow Transports bounced 59% from the March low despite very poor traffic numbers, while the S&P 1500 Financial Sector doubled from its March low amid continued deterioration in home values and loan portfolios. Transportation and financial stocks seem likely to face more negative headlines in coming months, and their ability to weather such news should shed light on how much bad news has already been discounted.

Conclusion
Dow Theorists divide bull markets into three phases. The first reflects reviving confidence in the business outlook; the second reflects rising earnings and dividends; and the third reflects speculation.

If the rally since March was the first stage of a bull market, the averages should find support above the March lows as investors anticipate improvement in the economy. If the advance since March was a bear-market rally, the March lows will be broken as the revival in confidence crumbles amid economic weakness.


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