Looking For Confirmation

10/26/2009


Early September-quarter reports have been mostly encouraging, and the major averages are trading near their highs for the year. But better-than-consensus earnings have failed to lift several bellwether stocks, suggesting companies are finding it more difficult to surpass investors’ expectations.

In addition to earnings reports and economic news, near-term trading will hinge on the dollar and the outlook for interest rates. While the Federal Reserve is widely expected to keep short-term interest rates near 0% well into next year, acceleration in the pace of the dollar’s decline could force policy makers to rethink their strategy. For now, as a partial hedge, we’re keeping about 25% of equity portfolios in a short-term bond fund.

Reviving confidence

While we believe the last confirmed signal under the Dow Theory was the move to new lows in March, this view does not preclude the possibility that a new bull market began in March. After all, distinguishing between a bear-market rally and the first stage of a new bull market is impossible at first.

If such an advance falters and both the Dow Industrials and Dow Transports move below the prior bear-market lows, the move was a bear-market rally. If the averages suffer significant corrections without moves to new lows in both averages — then both averages rebound above the points at which the corrections began — the rally was the first stage of a new bull market.

So, without a significant market correction, Dow Theorists will face uncertainty regarding the primary trend. Because the primary trend is presumed intact until proved otherwise, the Dow Theory remains in the bearish camp. But nothing says the Dow Theory must be used in an all-or-nothing fashion, and we have lowered our cash position since March based on the opportunities available in individual stocks.

According to legendary Dow Theorist Robert Rhea, bull markets have three phases: “The first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporation earnings; and the third is the period when speculation is rampant.”

With investors’ confidence in the outlook for capitalism up sharply — and stocks no longer cheap based on trailing earnings — the profit outlook will be crucial. Increasingly, investors will be looking for companies capable of sustained profit growth.

If such companies are not available in sufficient numbers, the market will stall or slump. Either way, we expect a rotation out of the speculative stocks that were priced for extinction in March — and into higher-quality names with solid growth prospects. Top picks on this theme include AmerisourceBergen ($24; ABC), Hospira ($46; HSP), and IBM ($123; IBM).


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