Broad-Based Selling

5/24/2010


Continued worries about the euro zone’s debt problems have triggered a global flight out of risky assets, pushing the Dow Industrials and Dow Transports near the two-month closing lows reached May 7. Near-term trading seems likely to be volatile, but we do not recommend a wholesale move out of stocks.

Subscribers should continue to look for buying and selling opportunities one stock at a time. For now, our Focus List and Buy List have 10.1% in Vanguard Short-Term Investment-Grade ($10.74; VFSTX), while our Long-Term Buy List has 12.5% in this relatively low-risk bond fund.

Euro malaise

While the European Union’s bailout plan has reduced sharply the risk of a near-term bond default from a euro zone government, the lack of a coherent long-term plan for dealing with the region’s most debt-burdened economies has kept pressure on the euro — and extended a flight to safety among investors.

Even if euro zone members make the spending cuts and/or tax increases necessary to get their fiscal houses in order, bears argue, the medicine may be worse than the disease for equity investors. Austerity measures in Europe, along with China’s efforts to slow its booming economy, are expected to crimp global growth over the next year.

Indeed, even as the euro has found a little support in recent days, economically sensitive stocks have paced a broad-based retreat in the U.S. Energy and materials stocks have been hurt by a sharp drop in commodity prices, while shares of industrials have slumped on concerns regarding overseas demand.

Despite mostly upbeat U.S. economic data, the Dow Transports — historically a good barometer of the outlook for the U.S. industrial sector — are trading nearly 9% below the May 3 closing high. The Transports are roughly 2% above their May 7 closing low of 4,298.12, while the Industrials are within 1% of their May 7 closing low of 10,380.43.

A break below the May 7 levels in both averages would be a discouraging development — and perhaps a reason to hold some extra cash as a near-term hedge. But we are not convinced a move below the May 7 levels would represent a bear-market signal, as it seems more plausible to view the entire decline since April as a single correction.

Conclusion

Holding some cash on the sidelines makes sense. But with quality stocks available at reasonable valuations — and this year’s new highs the last confirmed signal under the Dow Theory — we are sticking with a mostly invested posture. DirecTV ($38; DTV) represents a top pick for new buying.


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