New Highs Elusive


U.S. stocks have been under pressure since mid-July, with the Dow Transports slumping on weakness in airlines, railroads, and truckers. For now, our buy lists have about 23% in a short-term bond fund.

Textbook test for the averages

While the proportion of big companies beating consensus sales and earnings estimates for the June quarter is above recent norms — and the share-price reaction of individual stocks to quarterly results has been slightly better than in recent quarters — the broad market has moved slightly lower since mid-July.

The Dow Transports, hurt by some downbeat profit forecasts, have dipped nearly 4% since July 14. The Transports need to gain more than 5% to surpass the April 20 closing high of 8,109.19, and a close above that level is needed for a bull-market signal under the Dow Theory.

For those who question whether it makes sense to attach so much importance to the Transports, we make five points:

• The Dow Theory has compiled an impressive record of keeping investors on the right side of the market over the last century. The Dow Theory does not always work, and it is less effective in sideways-trending markets. But a system like the Dow Theory needs clear rules, and recent market action has set up a textbook test for the averages.

• The Transports are not sending a misleading signal. The average's recent action has been mirrored by broader, capitalization-weighted indexes of the transportation sector, as well as other gauges of economically sensitive stocks. Recent economic reports suggest the U.S. industrial economy is barely growing, and businesses remain very reluctant to spend on capital equipment.

• The Transports had rallied to within 1.2% of 8,109.19 before earnings-reporting season began, so even a little good news would have been enough to trigger significant highs. Investors always look forward, and the results and guidance provided by transportation companies have not been encouraging.

• More cyclical stocks have the most upside potential today, so the failure of the Transports and other cyclicals to rally bodes poorly for the broad market. As explained in this week's cover story, stocks with the most sensitivity to stock-market movements have the cheapest valuations today. Such stocks tend to be those most exposed to the ups and downs of the business cycle.

• We're not 100% cash. Nothing says the Dow Theory must be used in an all-or-nothing fashion, and we don't believe in timing the market in an all-or-nothing fashion. As we see opportunities in individual stocks, we won't hesitate to adjust our cash position. However, we're unlikely to near a fully invested posture until both averages are reaching significant highs.

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