Too Early To Sell


The market's post-election rally continues, with cyclicals and small stocks pacing the advance. While the extent of the rally in these sectors and the surge in bullish sentiment are a bit worrisome, we think it's too early to sell. In fact, after this week's upgrades our buy lists have 94.3% to 94.4% in stocks.

Dow Theory perspective

Under the Dow Theory, a bear-market signal occurs when both the Dow Industrials and Dow Transports break below significant low points. With both averages recently closing at all-time highs, there is no ambiguity about what must occur for such a signal.

• First, both averages must suffer significant corrections. From current levels, typical one-third to two-thirds corrections of the advances from the June 27 lows would bring declines of 800 to 1,600 points in the Industrials and 760 to 1,520 points in the Transports.

• Second, both averages must rally significantly, with one or both failing to surpass the highs established in the current rally.

• Third, both averages must break below the lows established in the corrections.

Even with a textbook example of a Dow Theory sell signal, there is no guarantee it will lead to a bear market. And you never know whether a bear market will be a 15% to 20% pullback or a 40% wipeout.

For perspective, early Dow Theorists liked to divide bull markets into three phases. In the first, reviving confidence in the future of business helps stocks return to known values. In the second, stocks advance as corporate earnings improve. In the third, speculation is rampant and stocks advance on hopes and expectations.

Ultimately, the distinction between phases two and three comes down to a judgement call informed by your answers to questions like the following:

Are stocks clearly overvalued? By nearly any measure, U.S. stocks are richly valued. But, relative to historical norms, they remain attractively valued compared to bond yields. Also, we still see some decent values, especially among somewhat volatile shares of cyclical growers like Lear ($137; LEA).

Is sentiment overwhelmingly bullish, with investors accepting "new era" rationalizations to justify rich stock valuations? Earnings are not keeping pace with stock prices, and the optimism regarding what's expected from Washington seems a bit overdone. But the profit outlook was improving before the election, and a cut in corporate taxes would by itself provide a meaningful boost to earnings. Sentiment surveys and mutual-fund inflows suggest investors are bullish — but not yet at the extreme levels sometimes seen at market peaks.

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