Industrials Near Key High

3/15/2010


The Dow Transports closed above their Jan. 11 closing high of 4,262.86. If the Dow Industrials confirm that move by closing above their Jan. 19 closing high of 10,725.43, our target cash position will be reduced to 15%. Here’s why:

The price movement. When both the Industrials and Transports reach significant highs, the primary trend is presumed bullish under the Dow Theory. A more substantial correction would have made it easier to categorize the January highs as significant. But labeling the entire advance since March 2009 as a bear-market rally becomes less tenable with each passing month, and a joint move to fresh 17-month highs would make it even harder to argue that the primary trend is down.

New highs would lend credence to the idea that we erred in not seeing last year’s pullbacks from the May and June highs as significant — in which case this year’s correction would also qualify as significant.

After reaching 8,799.26 on June 12, the Industrials fell to 8,146.52 on July 10, retracing 29% of the preceding advance. The Transports fell from 3,404.11 on May 6 to 2,999.45 on May 13, a 32% retracement.

A typical secondary correction retraces 33% to 67% of the preceding advance over three to 12 weeks, so neither average met the textbook definition of significant. Still, there is nothing magical about 33% to 67% retracements, and the rebound since March has endured far longer than a typical bear-market rally.

From July 10 to Jan. 19, the Industrials gained 2,579 points, then retraced 32% of that advance with a pullback to 9,908.39 on Feb. 8. The Transports gained 1,263 points from May 13 to Jan. 11 before retracing 37% of that advance with a pullback to 3,792.89 on Feb. 8. So, if one assumes the preceding advances began in July and May, this year’s corrections came very close to the textbook definition.

Fundamentals are improving, and valuations appear reasonable. Roughly one-half of S&P 500 companies delivered at least 8% year-to-year growth in per-share earnings in their most recent quarter. The median S&P 500 stock trades at 16.2 times trailing earnings, an 11% discount to the norm since 1992 of 18.2. Relative to bond yields, stock valuations are quite cheap versus historical norms.

High-quality stocks appear especially attractive. After underperforming since March 2009, shares of companies with superior track records, predictable earnings growth, and above-average growth prospects are comparatively cheap. Our Quadrix®-driven, growth-at-a-good-price approach seems well suited for such an environment.

Conclusion

A failure to close above 10,725.43 in the Industrials would be discouraging. A close above that level would not remove all doubt regarding the state of the Dow Theory, but with such a breakout we’d view the weight of the evidence as being in the bullish camp. With a close above 10,725.43, check our hotline for specific instructions.


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