Trading Range Intact, For Now

10/3/2011


Despite wide swings the averages have avoided a decisive break below the August lows. With Europe struggling to avoid a sovereign debt default and avert a banking crisis — and the U.S. earnings season due to start in mid-October — continued volatility seems likely in the near term. For now, as a partial hedge, our buy lists have about 22% in Vanguard Short-Term Investment-Grade ($10.67; VFSTX), a relatively low-risk bond fund.

Dow Theory analysis

The Dow Transports closed below their August low of 4,221.60, but the Dow Industrials have avoided a close below their August low of 10,719.94. A close below that level would reconfirm the bearish primary trend. But if the Industrials can avoid a close below 10,719.94, a rally above the August highs of 11,613.53 in the Industrials and 4,683.96 in the Transports would suggest the primary trend is bullish.

Under the Dow Theory, both the Industrials and Transports need to reach significant lows or significant highs for a valid market signal. The Industrials closed within 14 points of 10,719.94 on Sept. 22, and some have questioned whether it makes sense to consider the Dow Theory when its implications hinge on such minor amounts. For several reasons, we think the answer is yes:

• First, the Dow Theory works. While not perfect, the Dow Theory has a century-long record of keeping investors on the right side of the primary trend. Recent bear-market confirmations in September 2008 and August 2011 were followed shortly thereafter by sharp declines. Our use of the Dow Theory helped Dow Theory Forecasts outperform the market on both an absolute and risk-adjusted basis for the five, 10, and 15 years ended June 30, according to the Hulbert Financial Digest.

• Second, the Dow Industrials are moving in line with broader indexes. Some criticize the Dow Theory for its reliance on the 30-stock Dow Industrials and 20-stock Dow Transports. But this year the Dow Industrials have been charting a similar path to the broad S&P 500 Index and the all-stock Wilshire 5000 Index. For the S&P 500, a close below the August low of 1,119.46 would be discouraging.

• Third, a system needs rules. Without precise definitions on what represents a bull- or bear-market signal, testing and revising a market-timing system is very difficult. While waiting for a bear-market signal can mean selling with the crowd rushing to the exits, nothing in the Dow Theory says you can't act in advance of an actual signal. The Dow Theory says you should respect the market's opinion when it reaches a conclusion. But sometimes it will make sense to anticipate a signal, then reverse course if the market says you made a wrong move.


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