Averages Under Assault

2/1/2010


While the Dow Theory is often viewed as a prediction tool, it is best viewed as a system. When both the Dow Industrials and Dow Transports are reaching significant highs, higher stock prices are likely. When both are reaching significant lows, lower prices are likely.

While that sounds simple enough, determining whether new highs or lows are significant can sometimes be problematic. Other times, like the 10 months ended January, the averages will make extended and uninterrupted runs, meaning even a mere “correction” in the other direction could represent a 20% or 30% move.

Thankfully, however, using the Dow Theory as a system will typically put you on the right side of major market moves — even when the state of the Dow Theory is not crystal clear.

As we’ve said before, we see three Dow Theory explanations for today’s market: (1) the advance since March represents a massive bear-market rally; (2) the advance since March has been the first stage of a new bull market; or (3) the modest declines in May and June were significant, meaning a bullish trend was confirmed when the averages reached new 2009 highs in July.

All three explanations are plausible, though No. 3 could lead to changes in the primary trend based on fairly minor market shifts. Still, there is nothing magical about defining a significant correction as a one-third to two-thirds retracement of the previous market move, and we lowered our cash position in 2009 as the likelihood of a move below the March lows lessened.

If the averages suffer significant corrections without closing below the March lows and then rebound to new highs, the primary trend will be confirmed as bullish under the Dow Theory — and we’ll be looking to lower our cash position further. If the averages correct, fail to rebound to new highs, and then move below the lows established in the correction, the primary trend will be bearish — and we’ll be looking to raise cash.

Of course, the big risk with this game plan is the potential for a move directly through the March lows. But with those points more than 35% below current levels — and high-quality stocks trading at attractive relative valuations — that is a risk we are willing to take for now.

Conclusion

One-third to two-thirds retracements of the March-to-January advances would bring the Industrials to 9,333 to 7,940 and the Transports to 3,558 to 2,852. Whether or not the current pullback turns into a significant correction, the risk of a decline in coming months seems relatively high. As a partial hedge, we recommend holding 20% to 25% of equity portfolios in a short-term bond fund until the averages provide greater clarity.


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