Averages Under Assault

5/31/2010


Our recommended cash position depends primarily on two things: the market’s primary trend and the opportunities available in individual stocks. Today, these considerations are pulling us in opposite directions.

The primary trend. For Dow Theorists, the central question is whether the pullback to the points reached May 7 represented a significant correction — or whether the entire decline from this year’s highs should be viewed as one correction. Typically, a secondary correction retraces one-third to two-thirds of the preceding advance over three to 12 weeks.

Based on the proportion of the preceding rallies that were retraced, the pullbacks to May 7 qualified as significant for both the Dow Industrials and Dow Transports. But the pullback in the Industrials lasted less than two weeks, while the drop in the Transports took four days. Moreover, the rebounds from May 7 to May 12 comprised just three trading days.

Some Dow Theorists argue that any move resulting in a net reversal exceeding 3% of the price of the averages should be viewed as significant, meaning the rally from May 7 to May 12 qualified the May 7 points as significant lows. Others argue that the duration of market moves is crucial.

For our money, we don’t believe the Dow Theory always provides clear-cut, unambiguous signals. Sometimes the averages deliver mixed guidance, and in such cases investors should take partial measures until the ambiguity is resolved.

A failed attempt at new highs from current levels, followed by a move below the lows established in the current correction, would put the Dow Theory squarely in the bearish camp. A near-term move below the Feb. 8 lows of 9,908.39 and 3,792.89, while not strictly significant under the Dow Theory, would not be typical bull-market action.

The opportunities available in individual stocks. With the median stock in the S&P 500 Index trading at less than 15 times expected current-year earnings, the broad market seems reasonably valued relative to historical norms — and downright cheap relative to today’s bond yields.

More important, high-quality stocks are available at discount valuations. Among the 37 recommendations on our Buy List or Long-Term Buy List, the median stock trades at less than 13 times expected current-year earnings, despite a median expected profit gain of 12% this year.

Conclusion

Recent market action has been discouraging, and we have raised some cash as a defensive hedge. But we’re not convinced we’ve seen a bear-market signal, and we continue to find high-quality growers trading at attractive valuations.


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