Averages Pause Near Key Highs

12/12/2011


After closing within 1% of the Oct. 28 closing highs, the Dow Industrials and Dow Transports have paused amid choppy, headline-driven trading. For now, our three-part advice is unchanged:

Watch the averages. With closes above the Oct. 28 highs of 12,231.11 in the Industrials and 5,025.09 in the Transports, the market's primary trend should be regarded as bullish, according to the Dow Theory. A near-term pullback without new highs in both averages would be discouraging, and a failed attempt at new highs followed by a breakdown below the respective Oct. 3 lows of 10,665.30 and 4,038.73 would be very bearish.

Keep some powder dry. As a partial hedge, our buy lists have 21% to 22% in a short-term bond fund, with the remainder in stocks. A 21% to 22% bond-fund position will not provide much protection from an outright stock-market crash, but we will be well-positioned to take advantage of buying opportunities that develop in a market downturn. Also, we are likely to reduce our stock-market exposure if the averages break below the Oct. 3 lows, which would require declines of about 12% for the Industrials and 19% for the Transports from current levels.

Emphasize attractively valued shares of high-quality companies. Despite advancing more than 15% since the beginning of October, the typical U.S. stock trades at a discount to 20-year norms based on price/earnings and price/cash flow ratios. Relative to U.S. bond yields, the earnings and cash-flow yields of U.S. stocks are quite attractive versus historical averages.

The large stocks in the S&P 500 Index are particularly cheap relative to historical norms and relative to small stocks, and many blue chips seem cheap considering their expected growth rates. Cheap stocks, or those with high Quadrix Value scores, have lagged so far in 2011. But top Overall scorers have outperformed modestly, and we expect our growth-at-a-good-price approach to pay dividends in 2012.

Blue chips with particular appeal for the year ahead include Agilent Technologies ($37; A), Apple ($391; AAPL), and DirecTV ($47; DTV). All three earn Overall Quadrix scores of at least 95, with Value scores above 70.

Plan of action

Near-term trading will likely be dominated by economic reports and headlines regarding the European debt crisis. With closes above 12,231.11 in the Industrials and 5,025.09 in the Transports, our telephone and Internet hotlines will be updated with specific instructions. Our current plan is to lift our stock-market exposure to about 85% immediately with a bull-market confirmation. After that, we plan to add exposure based on the opportunities available on a stock-by-stock basis.


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