Proceed With Caution

10/24/2011


Hopes for a resolution to the European sovereign debt and banking crises lifted the averages to two-month highs. With near-term trading likely to hinge on September-quarter results and news from Europe, continued volatility seems likely. Subscribers should maintain a somewhat conservative stance, holding about one-fourth of equity portfolios in a short-term bond fund. With the remainder, subscribers should emphasize attractively valued shares of quality companies.

The state of the Dow Theory

Just nine trading days after Oct. 3 closes at the lowest levels in at least 12 months, the Dow Industrials and Dow Transports rebounded above their August highs. Because neither average held above this summer's closing lows, the move above the August highs is not a bull-market signal under the Dow Theory.

If Oct. 3 represents the end of the bear market that began April 29 in the Industrials, the Dow Theory will view the rallies since Oct. 3 as the first advance of a bull market. Of course, every bear-market rally is potentially the first leg of a new bull market, so the Dow Theory insists on confirmation of an uptrend.

For a return to the bullish camp, two things must happen. First, the averages need to correct without both moving below the Oct. 3 closes of 10,655.30 in the Industrials and 4,038.73 in the Transports. Second, both need to rebound above the highs established in the bounce since Oct. 3.

The relatively high hurdle required for a bull-market confirmation is one of the strengths of the Dow Theory. It is also one reason the Dow Theory can be slow to get you back into stocks after the market bottoms. For that reason we prefer an incremental rather than an all-or-nothing approach to market-timing, and our cash position also depends on the opportunities available in individual stocks.

Conclusion

While many quality stocks are trading at attractive valuations, the helter-skelter action of the averages makes us reluctant to deploy all of our cash reserves. For now, as a partial hedge, our buy lists hold just under 25% in Vanguard Short-Term Investment-Grade ($10.64; VFSTX), a relatively low risk bond fund with a 1.9% yield.

We intend to take advantage of buying and selling opportunities in individual stocks, and we will not be afraid to buy a stock that rallies on strong third-quarter results. But until the averages begin charting patterns of higher highs and higher lows, we are likely to maintain a meaningful position in short-term bonds. For new buying, especially timely picks include Google ($591; GOOG), DirecTV ($47; DTV), and Intel ($23; INTC).


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