Breaking Out Is Hard To Do

11/1/2010


Mostly favorable earnings reports helped bring the Dow Industrials and Dow Transports within 1% of this year’s closing highs, but neither average has managed to close at new highs. Closes above 11,205.03 on the Industrials and 4,806.01 on the Transports would signal that this summer’s pullback was likely a correction in an ongoing bull market. A failure to close at new highs would heighten the risk of a market retreat.

With midterm elections on Nov. 2 and the Federal Reserve Board expected to unveil its plans for quantitative easing, or money-printing, on Nov. 3, near-term action could prove telling. For now, we’re holding 25% of our Focus List and Buy List and 26.4% of our Long-Term Buy List in Vanguard Short-Term Investment-Grade ($10.88; VFSTX), a low-risk bond fund. With closes above 11,205.03 and 4,806.01, our bond exposure will be cut to a range of 10% to 20% and our hotline will be updated.

Significant highs

Does it really make sense to worry about the precise levels of the 30-stock Dow Industrials or 20-stock Dow Transports, both of which are price-weighted averages? To an extent, yes.

First, a theory needs quantifiable, testable rules. The idea that a bull market is confirmed only when both averages reach significant closing highs is central to the Dow Theory, and its more than 100-year track record is premised on that requirement.

Second, previous high points often become points of resistance, partly because pessimists view rallies approaching previous highs as selling opportunities. When this resistance is overcome and stock prices reach new highs, it suggests the demand for shares exceeds the supply of shares for sale. Charles Dow liked to compare stock-market fluctuations to waves on the beach; when the tide is rising, the high points of incoming waves will surpass previous high points. When incoming waves begin to fall short of previous high points, the tide has likely turned.

Third, new highs typically signal that fundamentals are improving. Short-term swings in sentiment can carry stocks to unsustainable levels. But when both averages surpass points reached at a time of high optimism, it typically signals that underlying equity values are trending higher.

Conclusion

As always, our stock-market exposure will hinge on the primary trend and the opportunities available in individual stocks. As shown below, the median S&P 500 stock is not particularly cheap or expensive relative to historical norms. But we are still finding high-quality growers trading at attractive valuations, so a move to new highs in the Industrials and Transports would be reason enough to boost our stock-market exposure.

MEDIANS FOR S&P 500 STOCKS
Price/
Earnings
Ratio
Price/Cash
Flow Ratio
Price/Sales
Ratio
Recent
16.4
11.1
1.5
March 31, 2009
9.8
7.3
0.8
Sept. 28, 2007
18.0
12.7
1.7
Norm since 12/94
18.2
11.3
1.4
Norm since 10/05
16.1
11.1
1.4
Excludes values above 75 or below 0.

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