Markets slide raises questions

6/30/2008


Amid widespread pessimism, the Dow Industrials have retreated close to the March low of 11,740.15. The Dow Transports have held up comparatively well but are down about 9% from the June 5 all-time high of 5,492.95. While recent market action has generated several questions from subscribers, we’re sticking with our recommended cash position at 15% to 20% for now.

Q It seems obvious that stocks are trending lower, so how can the primary trend be bullish under the Dow Theory?
A Both the Industrials and Transports reached significant highs in April, and a bull-market signal remains intact until proved otherwise. For the Dow Theory to shift into the bearish camp, both averages will need to rally, with at least one average failing to reach new highs. Next, both averages will need to close below the lows reached in the current correction.

Q But wouldn’t a move below the March low in the Industrials invalidate April’s bull-market signal?
A No, a move below the March low of 11,740.15 would be unusual and discouraging, but it would not invalidate the bull-market signal. In fact, unconfirmed new lows often represent buying opportunities.

Q Still, isn’t the whole point of the Dow Theory to determine the stock market’s trend? Wouldn’t it make sense to take a broader view and conclude that stocks are trending lower?
A Investors should always consider whether the Industrials or Transports are sending a false signal. But, if anything, the Industrials seem to be exaggerating the market’s weakness. Based on broader measures like the capitalization-weighted S&P 500 Index or equal-weighted Value Line Arithmetic Index, the market has retraced about two-thirds of the rally off the March lows — within the parameters of a typical bull-market correction.

The Transports have performed in line with broader measures of the transportation sector. One concern is the recent weakness in the Morgan Stanley Cyclical Index, which historically has tracked the Transports.

Q Don’t you read the newspapers? With the financial sector in dire shape and oil prices above $130 per barrel, why should I maintain stocks at 80% to 85% of my equity portfolio?
A First, the stock market does not trade upon what everybody knows. Today’s headlines explain yesterday’s stock prices; they don’t predict tomorrow’s.

Second, if stocks climb a wall of worry, conditions are ripe for a bounce. Newsletter sentiment is very pessimistic, with bears outnumbering bulls. Short interest is near record levels, and consumer confidence is at its lowest level since 1992.

Third, we’re still finding attractively valued growers. BMC Software ($38; NYSE: BMC) is a top pick.


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