Grounds For Concern

8/24/2009


Hurt by doubts about China’s ability to power a global recovery, the averages have pulled back from the nine-month highs reached Aug. 13. A market correction seems overdue, and history suggests a one-third to two-thirds retracement of the advance since March is likely at some point. From the Aug. 13 closes, such a correction would bring the Dow Industrials to about 7,500 to 8,450, while the Dow Transports would reach 2,700 to 3,230.

History also suggests that timing secondary corrections with precision is very difficult — and that timing the market in an all-or-nothing fashion is a good way to wreck the long-term returns of your portfolio. As always, our stock-market exposure is meant to balance potential reward and potential risk, giving consideration to both bullish and bearish factors.

For now, all things considered, holding about 30% of equity portfolios in a short-term corporate bond fund seems prudent. Among the factors considered in determining our stance:

The Dow Theory has not provided a bull-market confirmation. Without significant corrections in both averages and rebounds to new highs, the move to new lows in March represents the last confirmed signal under the Dow Theory.

The market appears overbought on a near-term basis. About 88% of NYSE stocks are trading above their 200-day moving averages. Historically, such an extreme reading versus historical norms has signaled an increased risk of a market correction.

Sentiment seems exuberant. Among newsletters monitored by Investors Intelligence, the ratio of bulls to bears is near 19-month highs. Among investors surveyed by the American Association of Individual Investors, bullish sentiment has increased for five straight weeks to 51%. While sentiment can always become even more exuberant in the short term, history suggests that corrections tend to begin amid widespread bullishness.

Downside economic surprises have become more likely. The idea that the U.S. recession is over has quickly become the consensus view, and investors seem unduly complacent regarding the global economy’s reliance on China — a command economy that has been revived by massive monetary stimulus.

Corporate insiders are selling into the rally. According to Insiderscore.com, companies with selling recently outnumbered those with buying by a more than 2-to-1 ratio for the first time since February 2007. Insiders are often wrong on individual stocks, but widespread selling is a bearish development.

On the plus side, the quality stocks we favor seem less vulnerable to a correction. The rally since March has been led by shares of the companies with the worst finances and track records. As a result, many of the fundamentally superior companies we emphasize are trading at relatively attractive valuations.


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