Cyclicals Lead Market Bounce


The Dow Industrials closed above their Sept. 16 closing high of 16,739.95, while the Dow Transports moved within 2% of their Sept. 17 closing high of 8,215.44. We'd see a close above 8,215.44 in the Transports as a bull-market confirmation under the Dow Theory — and as a reason to increase our stock-market exposure. For now, our buy lists have 68% to 70% in equities, with the remainder in a short-term bond fund.

Sector rotation

Without confirmation from the Transports, we are likely to maintain a somewhat defensive posture. All things considered, we'd prefer the Transports hold off on reaching significant highs until earnings-reporting season is fully under way, as any rally could be quickly undone by a flurry of worse-than-expected profit reports.

We'd also prefer if stocks were rallying on good news rather than bouncing on a sentiment-driven rally fueled by short-covering and portfolio managers' fears of being left behind in a rally. After all, many commentators blamed the market's late-September slump on the Federal Reserve's decision to hold short-term interest rates at 0%, saying the Fed's inaction raised fears about whether the U.S. economy could fall victim to the slowdowns in China and elsewhere. Yet, since a weaker-than-expected September employment report seemed to confirm those fears, stocks have marched higher, with many saying the rally reflects expectations that interest rates will remain low for the foreseeable future.

Still, subscribers should not make too much of such seeming contradictions. For one thing, rallies often start simply because investors have become too pessimistic, which means even a glimmer of positive news can trigger buying from underinvested investors. Such rallies, if driven purely by sentiment, will often stall below previous significant highs.

For another, nobody knows exactly why stocks are advancing or declining in real time. Stocks don't rise on good reports and fall on bad ones; they rise on better-than-expected reports and fall on worse-than-expected ones. And sometimes it's not easy to know what's good or bad news for the market in aggregate.

For example, the weak September job report lowered expectations for near-term economic growth and corporate profits. But it also diminished expectations for higher U.S. interest rates and a higher U.S. dollar, helping the sectors most exposed to flagging overseas economies.

The beaten-down energy, materials, and industrial sectors have been among the market's best performers since late September. The financials have lagged, partly because higher interest rates are expected to help the sector's earnings.

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