Bullish Trend Confirmed

2/21/2011


The Dow Industrials and Dow Transports reached fresh multiyear highs on Feb. 11 and again on Feb. 16, reconfirming the bullish primary trend under the Dow Theory. While the reconfirmation does not preclude a pullback, it does signal that such a correction should be viewed as a buying opportunity. For now, a mostly invested, opportunistic posture remains appropriate. As a partial hedge, our buy lists hold 10% to 15% positions in Vanguard Short-Term Investment-Grade ($10.75; VFSTX), a low-risk bond fund.

Beware complacency

In his 1932 classic, The Dow Theory, Robert Rhea wrote that when "both averages have penetrated the highest points previously attained in a primary bull market, it is generally safe to infer that the primary bull trend will continue for a considerable period of time."

Rhea's use of the word "generally" is worth noting, for he did not view the Dow Theory as an infallible system. The Dow Theory is an empirical science like piloting — not an exact science like arithmetic. Just as a pilot should not relax because of an all-clear signal from the control tower, a Dow Theorist should not relax because of a bull-market confirmation.

Remember, a bull-market confirmation does not reduce the probability of a near-term decline; it signals that any such pullback should be viewed as a secondary correction in an ongoing bull market. Anticipating such corrections is notoriously difficult, but investor sentiment and market technicals can provide some insight.

Based on surveys among fund managers, newsletter editors, and individual investors, bullish sentiment is unusually high. In fact, a recent global survey by Merrill Lynch indicated that fund managers are more bullish toward stocks than at any time in the past decade. Historically, such a high level of bullishness has often been a precursor to a market pullback.

At 79%, the percentage of NYSE stocks trading above their 200-day moving averages is high relative to historical norms. Historically, a percentage above 70% has signaled an increased risk of a correction.

Conclusion

Trying to time short-term market zigs and zags with precision is a fool's errand, and the most important signal of recent weeks was the Feb. 11 move to confirmed new highs. Moreover, with earnings growing and price/earnings ratios in line with historical norms, the year-ahead outlook for U.S. stocks remains favorable. Top picks include new recommendations Bard ($98; BCR), BlackRock ($206; BLK), and Lam Research ($54; LRCX).


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