Listen to the averages


Benefiting from improvement in the credit markets, the Dow Industrials and Dow Transports moved to four-week highs before retreating on earnings concerns. With more profit warnings likely, near-term market action could prove telling. For now, with the Dow Theory in the bearish camp, holding 25% to 35% of equity portfolios in cash remains appropriate.

The price action
Partly because the collective wisdom of investors is right more often than wrong, major stock-market trends usually do a good job of anticipating changes in the business environment. However, because stock prices also influence the decisions of consumers and investors, extended market moves can lead to excessive optimism or pessimism.

This second-order effect is one reason stock prices tend to overshoot at market extremes, rising excessively at bull-market peaks and dropping excessively at bear-market lows. Some argue that last year’s market decline was excessive, that the 16% snap-back in the Dow Industrials since Nov. 20 reflects recognition that the selling was overdone.

Others say the bounce is a typical bear-market rally. Bears argue that stocks and corporate bonds have rebounded only because the Federal Reserve’s move to bring short-term interest rates near 0% has forced investors into riskier assets, that such rallies are destined to falter until the economy begins to gain traction and investors are truly discounting better times ahead.

For Dow Theorists, this argument will be settled by the price action of the Industrials and Transports. A breakdown below the respective Nov. 20 closing lows of 7,552.29 and 2,988.99 would confirm that the bearish primary trend remains intact. If at least one average avoids new lows on a retest of the Nov. 20 levels — and then both averages rebound to significant highs — the Dow Theory would shift to the bullish camp.

As of yet, it is not clear that significant highs have been established. At the rebound highs reached this month, the Industrials had retraced 27% of their May-to-November drop, while the Transports had retraced 29%. Typically, significant rallies retrace 33% to 67% of the preceding decline. Still, the longer the averages trade above the Nov. 20 lows, the more difficult it will be to label the rallies from those lows as insignificant.

Our cash position may be reduced somewhat in coming weeks as opportunities develop in individual stocks, but we intend to hold sizable cash reserves until the Dow Theory signals a bull market. Especially attractive names include Accenture ($33; ACN) and Biogen Idec ($46; BIIB).

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