Selling On The News

9/7/2009


On Sept. 1, a day that saw better-than-expected reports on manufacturing activity and home sales, the Dow Industrials lost 186 points. Extrapolating much from one day is dangerous, but the Industrials are roughly unchanged from levels reached two weeks ago despite mostly encouraging economic reports.

The index of Leading Economic Indicators has increased four months in a row, and consensus estimates now project the U.S. economy will grow at a 2.9% annual rate for the September quarter. The IMF expects the world economy to grow nearly 3% in 2010, an improvement from the July estimate of 2.5%.

The market’s tepid reaction to the largely upbeat economic news has attracted notice from several market watchers. Among the leading explanations posited by these commentators:

Stocks typically rise in anticipation of better news. Once the news is actually out, it will already be reflected in stock prices. “Buy the rumor and sell the news,” like most long-lived adages, contains some wisdom.

Stocks discount expectations for corporate earnings, not the U.S. economy. While the two are correlated, U.S. companies are increasingly relying on streamlining and overseas operations to drive profit growth.

With governments around the world throwing everything and the kitchen sink at the economic downturn, the only real surprise would be continued shrinkage in the economy. But government stimulus efforts can carry the economy only so far, and the outlook for the two-thirds of the U.S. economy dependent on consumer spending is bleak.

All three explanations hold some truth. Bull-market corrections amid good news are not unusual, but the bears are right to question the sustainability of the economic recovery. While we continue to find attractive values — especially among reliable growers in health care and technology — we intend to hold some cash and watch developments under the Dow Theory.

In our view, the last confirmed signal under the Dow Theory was the move to new lows in March. If the rebound since March is the beginning of a new bull market, the Dow Industrials and Dow Transports should be able to correct without moving below the March lows — and then rebound to new post-March highs. If the rebound since March represents a bear-market rally, the March lows will be broken.

Either way, we expect a meaningful correction in coming months. Depending on the market’s course and the opportunities available in individual names, we may use the correction to put some money to work in stocks. For now, we’re holding about 30% of equity portfolios in Vanguard Short-Term Investment-Grade ($10.49; VFSTX), a relatively low-risk bond fund.


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