A Dangerously Blithe Indifference?

3/28/2011


U.S. stocks have rebounded impressively despite major global uncertainties, with the Dow Industrials and Dow Transports moving within 1% of the mid-February highs.

Some argue that the market's resiliency amid so many potentially destabilizing headlines reveals a dangerously blithe indifference on the part of investors, that stocks are headed for a fall once people stop looking on the bright side and realize:

• oil is up 11% since Dec. 31 to more than $104 per barrel, and the Middle East is coming apart at the seams;

• the number of bailed-out European nations is set to reach three with the likely near-term addition of Portugal;

• gold is trading at all-time highs versus the dollar amid doubts about the U.S. government's ability to service its debt load without inflationary currency debasement;

• and Japan's nuclear troubles have yet to be resolved, while the world's third-largest economy has suffered a massive shock.

Others argue that today's buy-the-dip mentality reflects an enduring shift into stocks and out of bonds, that yield-starved investors are realizing stocks are not just the only game in town but are also cheap relative to historical norms and relative to inflation and interest rates — especially considering the impressive earnings growth U.S. companies are delivering.

Dow Theorists argue that such arguments are best settled by the price action of the Dow Industrials and Dow Transports, that breakouts above previous significant highs and breakdowns below previous lows reveal the stock market's primary trend.

Core beliefs

Are the underlying values of shares in U.S. companies becoming more valuable or less valuable? Answering that question with measures of profit and interest-rate expectations is tough, so Dow Theorists take a shortcut, predicating their system on some core beliefs:

• In the main, the collective wisdom revealed in the action of the averages is correct. In other words, the majority money opinion usually gets it right.

• Sometimes sentiment will go to extremes, with stocks getting ahead of themselves or moving to an unjustified discount to underlying value because of the mood swings common in all bull and bear markets.

• When previous significant highs are surpassed, with the averages moving above highs reached at previous peaks in bullish sentiment, underlying values are probably rising and the market's primary trend is bullish. When the averages move below previous significant lows, underlying values are likely deteriorating and the primary trend is bearish.

• No such system is perfect, but investors can reduce the incidence of false signals by insisting on confirmation from both the Industrials and Transports.

Think of it this way: Today we are all getting a chance to sell near the highs reached in mid-February, when investor sentiment was quite optimistic. If investors don't see that as a selling opportunity — and both averages move above the mid-February highs of 12,391.25 on the Industrials and 5,298.10 on the Transports — it would suggest the majority money opinion remains in the bullish camp. For now, we intend to watch the averages while maintaining 9% to 15% of equity portfolios in a short-term bond fund. Apple ($351; AAPL) represents a top buy.


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