New Highs Reconfirm Bull Market


The Dow Industrials reached fresh all-time highs on Oct. 31, corroborating new highs in the Dow Transports and reconfirming the bullish primary trend under the Dow Theory. Broader, capitalization-weighted measures like the S&P 500 Index also reached all-time highs, as did unweighted measures like the S&P 1500 advance-decline line.

New highs in the Russell 2000 and S&P SmallCap 600 indexes would be encouraging, as continued underperformance from economically sensitive small stocks would represent a yellow flag for the U.S. economy, the resiliency of which underpinned much of the S&P 500's nearly 11% bounce from its Oct. 15 intraday low.

Still, with the major averages hitting all-time highs, determining the majority money opinion is not your central problem. At times like this, the bigger issue is deciding how much you want to stake on a continuation of the upward trend.

Every bear market begins with the indexes at significant highs, and history shows stock prices tend to outrun fair value in the final speculative stage of bull markets. So, even when the primary trend is unmistakably bullish, you should ask yourself two questions:

Is investor sentiment unusually bullish? Dow Theorists divide bull markets into three stages. In the first, stocks rebound from depressed levels. In the second, stocks rise based on improving earnings, cash flow, and dividends. In the third, irrational exuberance sets in — and stocks advance on hopes and expectations.

Have we reached the speculative third phase? We're encouraged that solid September-quarter results sparked the market's rebound. But we're a bit discouraged that bullish sentiment among investment newsletters and individual investors has rebounded to above-normal levels. Among Wall Street strategists, recommended equity exposures have risen in three straight months but remain below long-term norms, according to Bank of America.

Are stocks unusually expensive? Irrational exuberance is typically reflected in rich stock valuations. Today the S&P 500 Index trades at roughly 19 times trailing earnings — about 7% above the norm since 1946 but in line with the 50-year norm. Given today's low inflation and bond yields, U.S. stocks compare unusually favorably to bonds and cash.


The Dow Theory is squarely in the bullish camp. Sentiment and valuation indicators are somewhat worrisome but not yet at dangerous levels. Partly because the speculative third stage is often among the best periods of a bull market — and partly because we are still finding reasonably valued growers — we are maintaining a mostly invested posture. Our buy lists have 93% to 94% in stocks.

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