Earnings Season Begins Well

10/19/2009


Helped by a favorable start to earnings season, the Dow Industrials and Dow Transports have rallied above their September highs. While the moves to new highs do not represent a bull-market signal under the Dow Theory, they bode well for near-term market action.

Our stock-market exposure is being increased slightly, and our recommended equity portfolios now have about 75% in stocks. The remainder is in Vanguard Short-Term Investment-Grade ($10.57; VFSTX), a relatively low-risk bond fund with a 2.7% yield and 12.9% year-to-date return.

Dow 10,000

After slumping from 13,058.20 in May 2008 to 6,547.05 in March 2009, the Dow Industrials have rebounded by more than 3,400 points, recouping about 52% of the May-to-March decline. The Dow Transports, after slumping from 5,492.95 to 2,146.89, have rebounded more than 1,800 points to recoup about 54% of their decline.

A typical secondary reaction rally retraces one-third to two-thirds of the preceding move, so the rebounds since March still fall within the parameters of a bear-market rally. With two-thirds retracements, the Industrials would trade near 10,900 and the Transports would trade near 4,375.

However, secondary reactions typically endure three weeks to three months, so the rebounds since March have far exceeded the duration of a typical bear-market rally. Among possible explanations for this inconsistency, we see two as the most likely:

After one of the worst market declines on record, an unusually long and strong rally is to be expected. After the 1929 market crash brought the Dow Industrials to about 199, the average rallied more than 50% over nearly five months on hopes for economic renewal — only to plunge to 41 when those hopes proved unfounded.

We erred in labeling this summer’s market correction as insignificant — and should have turned bullish in July when the June highs were surpassed. The June-to-July decline in the Industrials retraced only 29% of the preceding advance, narrowly falling short of the 33% retracement typically required to label a correction as significant.

Only time will tell which of these two explanations is correct. For now, we’re hedging our bets by keeping nearly 25% of our recommended equity portfolios in a short-term bond fund. While this hedge has penalized recent performance, we still think it makes sense to hold some money in reserve given the likelihood of a correction — and the possibility of a major decline if the recovery falters despite the massive stimulus efforts of governments around the globe.


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