Defensive Names Support The Dow


Led by gains in such defensive names as Coca-Cola ($81; KO) and Wal-Mart Stores ($74; WMT), the Dow Industrials are within 3% of this year's high of 13,279.31 — and within 9% of the all-time high of 14,164.53. The large-stock S&P 500 Index, widely used as a benchmark for institutional investors, is within 3% of this year's high and within 14% of its all-time high.

The mainstream media is likely to view a move to all-time highs in the Dow Industrials and S&P 500 Index as a decisive verdict from the stock market, a signal that better times are ahead for U.S. investors. In our view, all-time highs in these indexes would not be a reason to boost our stock-market exposure, for three reasons:

• Under the Dow Theory, both the Dow Industrials and Dow Transports must reach significant highs for a bull-market confirmation. Closes above 13,279.32 in the Industrials and 5,368.93 in the Transports would reconfirm the bullish trend, while new highs in only one of the averages would not necessarily signal anything. In fact, an unconfirmed new high in one average is often a worrisome development. The Transports, hurt by weakness in truckers and airlines, are more than 7% from 5,368.93.

• Nearly all the market's recent strength has come from defensive, noncyclical stocks. The health care, telecom, and utility sectors have been the best performers over the past four months, while more cyclical sectors like energy, financials, materials, and technology have slumped. Nothing says all sectors must advance in unison in a healthy bull market. But defensive stocks already trade at unusually rich premiums to the average stock, so broader participation may be necessary to sustain the advance.

• A relatively poor earnings-reporting season has diminished the supply of attractively valued growers. While the stock market's reaction to earnings is all that matters for the Dow Theory, our stock-picking strategy emphasizes stocks with attractive valuations and earnings momentum. September-quarter earnings for the S&P 500 Index are now expected to be down 1% from the year-earlier quarter, according to Thomson Reuters. On July 1, September-quarter earnings were expected to rise 3.1%.


While we are still finding attractive stocks, we intend to hold some cash in reserve as we wait for confirmation from the averages. With closes above 13,279.32 in the Industrials and 5,368.93 in the Transports, we are likely to put some cash to work. With breakdowns below 12,101.46, and 4,847.73, respectively, we intend to cut our stock-market exposure to 75% immediately. For now, our buy lists have about 10% to 17% in Vanguard Short-Term Investment Grade ($10.81; VFSTX), a relatively low-risk bond fund. Wells Fargo ($34; WFC) is an especially attractive pick.

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