July Lows Loom Large

9/6/2010


After slumping within striking distance of the July lows, the averages have bounced on better-than-expected manufacturing data for the U.S. and China. Holding 25% to 30% of equity portfolios in short-term bonds seems appropriate for now. But a breakdown below the July closing lows of 9,686.48 in the Dow Industrials and 3,906.23 in the Dow Transports would represent a confirmation of the bearish primary trend — and a reason to take a more defensive near-term posture.

Low points

Volumes have been written about the transition from bull to bear markets, but legendary market technician Robert Rhea summarized the Dow Theory view in one sentence: “If, after a severe secondary reaction in a primary bull market, the ensuing rallies fail to go to new highs within a reasonable time and a further drastic decline occurs extending below the low points of the previous reaction, it is generally safe to assume the primary trend has changed from bullish to bearish.”

In our view, the June 30 breakdown below the early June lows in the Industrials and Transports was reason enough to prepare for a potential bear market. But some might quibble regarding the significance of the June lows, especially considering the averages’ rebound in July. With a breakdown below the July lows, bulls would have a hard time arguing the primary trend is up: Both averages would be at the lowest levels in at least six months after sharp rebounds that failed to eclipse previous highs.

In addition, a near-term breakdown below the July lows is likely to attract considerable media attention, for at least three reasons:

Sentiment. Investors are already pessimistic, with mutual-fund flows and surveys of individual investors revealing widespread skepticism toward stocks. Among newsletter editors tracked by Investors Intelligence, the percentage of bulls is at the lowest level since March 2009, while the percentage of bears is at the highest level since March 2009. With another leg down in the averages, today’s dislike for stocks could turn to hatred, prompting a final shakeout as more investors forsake stocks altogether.

The season. September has been the worst month for the Dow Industrials, with declines in 66 of the past 113 years. The average for all 66 declines is 4.7%, while the average for all 113 months is a loss of 1.2%.

News flow. Many blame September’s poor historical returns on profit warnings from companies ahead of third-quarter results. With consensus forecasts still projecting solid earnings growth in coming quarters, a surge in profit warnings would weigh heavily on sentiment.


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