Dow Theory

3/29/2010


At least a few readers were surprised our recommended cash position was cut nearly in half because the Dow Industrials moved above their January high. Others were surprised that a Dow Theory bull-market confirmation merited only a 10% reduction, to a range of 10% to 15% from the previous 20% to 25%.

While we can’t always please everybody, this newsletter works best when readers understand our reasoning. To that end, we provide three explanations for our behavior.

The price movement. With the Dow Industrials and Dow Transports at 17-month highs, rebounding to reach post-2008 highs for the second time after borderline significant corrections, it seems hard to argue the primary trend is bearish.

The Dow Theory is designed to call primary swings in the stock market — the bull or bear markets that tend to last a year or longer. When both the Industrials and Transports rebound to reach new highs after significant corrections, the primary trend is presumed bullish.

Doubting the significance of the May-to-July market pullback made some sense only four months after a bear-market low. Doubting the January-to-February pullback, more than a year into a broad market advance, makes less sense.

We don’t believe in timing the market in an all-or-nothing fashion. We’re not trying to be the No. 1 market timer, and we don’t pretend to know where the market is headed. We’re trying to balance risk and reward based on our conviction regarding the primary trend and the opportunities available in individual stocks.

For the most part, the results have been good. Excluding dividends and transaction costs, our Focus List has gained 229.8% (8.1% annualized) on a fully invested basis since its December 1994 inception, versus 155.3% (6.3%) for the S&P 500 Index. Including our cash position, the Focus List has gained about 293% (9.4%).

Quality stocks are available at attractive valuations. The median S&P 500 stock trades at a trailing price/earnings ratio of 16, versus the norm of 18 since 1991. As shown below, stocks are cheap based on the spread between Treasury bond yields and the median S&P 500 stock’s earnings yield (earnings/price ratio).

While stocks could be vulnerable if bond yields move higher or profit prospects deteriorate, valuations alone seem unlikely to halt the market advance. With relative valuations especially attractive among stocks with strong fundamentals, we expect our growth-at-a-good-price approach to outperform.


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