Keep Your Powder Dry

7/27/2009


Stocks have surged on better-than-expected earnings reports, lifting the Dow Industrials to six-month highs. While recent market action has been impressive, we would not view a breakout in the Dow Transports above their May high as a bull-market signal under the Dow Theory. For now, we’re keeping about 30% of equity portfolios in a short-term bond fund.

Significant points

In theory, applying the Dow Theory is simple. If both the Industrials and Transports reach significant highs, the Dow Theory is bullish. If both averages reach significant lows, the Dow Theory is bearish. If the averages move in opposite directions or meander without reaching significant highs or lows, the last signal confirmed by both averages remains in force.

In practice, determining which points qualify as significant is sometimes difficult. One could argue that a close above 3,404.11 in the Transports would return the Dow Theory to the bullish camp and call for a fully invested posture, since the Industrials recently moved above their June 12 closing high of 8,799.26. We disagree, for at least five reasons:

After rallying 2,252 points from March 9 to June 12, the Industrials fell about 653 points to reach 8,146.52 on July 10 — a 29% retracement of the March-to-June rally. In general, significant corrections retrace 33% to 67% of the previous advance.

The Transports rallied 1,257 points from March 9 to May 6 before slumping 405 points to reach 2,999.46 on May 13 — a 32% retracement in one week. Significant corrections typically last three weeks to three months, though it is worth noting that the Transports hit 3,062.96 on July 7.

The rebound since March, though long in duration, otherwise fits within the parameters of a bear-market rally. A one-third to two-thirds retracement of the decline from May 2008 to March 2009 would put the Industrials at 8,717 to 10,887. For the Transports, the equivalent range is 3,244 to 4,341. With both averages at the low end of these ranges, viewing the rebound since March as an uninterrupted bear-market rally makes sense.

Over the next few months, a more substantial correction would not be surprising. At 82%, the percentage of NYSE stocks trading above 200-day moving averages is high relative to historical norms, suggesting the risk of a correction is high.

Nothing says the Dow Theory must be used in an all-or-nothing fashion, and we will continue to look for opportunities among individual stocks. Moreover, our defensive approach is producing solid results. While our position in Vanguard Short-Term Investment Grade ($10.33; VFSTX) has crimped the returns of our recommended equity portfolios, the fund’s 9.4% year-to-date return has limited the drag on our results.


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