Dow Theory In Bearish Camp

7/5/2010


Stocks have slumped on heightened fears regarding a double-dip recession, pushing both the Dow Industrials and Dow Transports below their June 7 closing lows. The closes in both averages below those points — 9,816.49 on the Industrials and 4,037.98 on the Transports — suggest the primary trend is bearish under the Dow Theory.

Our recommended cash position is being increased to a range of 25% to 30%, up from the recent 15% to 16.3%. Depending on the reaction to June-quarter results and the opportunities available in individual stocks, we may adjust our cash position further. For now, as a partial hedge, subscribers should hold 25% to 30% of equity portfolios in a short-term bond fund like Vanguard Short-Term Investment-Grade ($10.73; VFSTX).

Economic gloom

Consensus estimates still project annualized U.S. economic growth of roughly 3% for the second half of 2010 and full-year 2011, but financial-market indicators suggest investors have become increasingly skeptical of such projections.

Prices for industrial commodities have dropped on indications of softening demand from China, while oil prices have been hurt by expectations of reduced global demand. The Baltic Dry Index, which measures freight rates for bulk goods, has dropped about 40% over the past month.

Bond yields also point to economic worries. Yields on two-year Treasury notes have dropped to 0.61%, a level not seen since the 1930s. Yields on 10-year Treasury bonds have moved below 3.0% for the first time since May 2009, partly because of renewed fears of deflation.

Most importantly, the Dow Transports and other economically sensitive stocks have slumped on worries regarding the U.S. and global economy. Since the end of March, the most cyclical sectors of the S&P 500 Index — energy and materials — have dropped more than 13%.

Meanwhile, earnings-estimate trends for the June quarter have been encouraging, with the ratio of positive profit warnings to negative warnings favorable relative to historical norms. According to Thomson Reuters, total per-share earnings for the S&P 500 Index are expected to be up 27% year-to-year for the June quarter.

Conclusion

While June-quarter results will be crucial, the breakdowns to significant lows in the averages suggest the majority money opinion has already rendered a verdict on the market outlook. While high-quality stocks are available at reasonable valuations, lifting cash as a hedge against further weakness seems prudent.


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