Sideways Trading Raises Questions


This week we are increasing the stock-market exposure of our buy lists slightly, mostly because we've identified some attractively valued growers. Vanguard Short-Term Investment-Grade ($10.88; VFSTX), the low-risk bond fund we use as a partial hedge, has been cut to 9.2% of our Buy List and 11% of our Long-Term Buy List. While there is no precise formula that determines these percentages, our stock-market exposure mostly reflects the answers to four questions:

1) Are the Dow Industrials and Dow Transports trending higher or lower? When both averages are reaching significant highs, the primary trend is bullish and further gains are likely. When both are reaching significant lows, the primary trend is bearish and further declines are likely.

Significant lows are the end points of significant secondary corrections, which typically retrace one-third to two-thirds of the preceding advance over three to 12 weeks. The declines that ended in mid-November more than satisfied those parameters, and the bounces from mid-November to late November qualified as legitimate retests. So, we'd view a breakdown below the mid-November closing lows of 12,542.38 in the Industrials and 4,891.27 in the Transports as evidence that the averages are trending lower.

While our earlier commentaries identified the respective June lows of 12,101.46 and 4,847.73 as key points — and a breakdown below these levels would provide a clear indication that the primary trend is bearish — we no longer feel it is necessary to wait for a breakdown below the June lows to conclude that the trend is bearish.

On the upside, a breakout above this year's respective highs of 13,610.15 and 5,368.93 would provide a clear indication that the primary trend remains bullish. A case can be made for viewing the Transports' June 19 high of 5,250.74 as significant, as that represents the high since the June low. But considering the long sideways pattern charted by the Transports this year, we'd like to see a true breakout in the Transports before issuing an all-clear signal.

2) Are stocks cheap? The Dow Theory aims to put market cycles in perspective, and values are a key part of such analysis. A breakout to new highs is more bullish when stocks are cheap than when stocks are expensive, as a cheap market usually has further to run on the upside.

Today stocks are very cheap relative to bonds and somewhat cheap relative to historical norms. At roughly 14 times trailing 12-month earnings, the S&P 500 Index trades at a modest discount to its 85-year norm of 16, according to Birinyi Associates.

The S&P 500 trades at 13 times expected year-ahead earnings, leaving room for upside if the profit outlook holds up. After the broadly disappointing results of the September quarter, results and earnings guidance for the December-quarter will go a long way toward explaining whether stocks are seen as cheap.

3) Are investors unusually bullish or unusually bearish? Sentiment indicators can be quite useful at turning points, as investors tend to be very bearish at market bottoms and very bullish at market tops. Today's sentiment readings suggest investors are somewhere between those extremes. The percentage of bullish investment newsletters is slightly below long-term norms, while surveys of individual investors suggest bullishness is in line with long-term norms.

4) Are attractive opportunities available in individual stocks? Investors are showing a clear preference for safe, defensive names with no blemishes. As a result, somewhat aggressive names like Mylan Laboratories ($27; MYL) and Thermo Fischer Scientific ($64; TMO) look particularly attractive.

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