Averages under assault


Succumbing to a steady drumbeat of profit warnings and renewed worries about the financial sector, the Dow Transports have retreated more than 15% from a high reached in early January. The Dow Industrials have dropped about 9%. A breakdown below the Nov. 20 lows of 2,988.99 in the Transports and 7,552.29 in the Industrials would confirm the bearish primary trend.

While subscribers should continue to look for opportunities on a stock-by-stock basis, holding a sizable cash reserve seems prudent. Our Focus List and Buy List hold 32.5% in Vanguard Short-Term Investment-Grade ($9.78; VFSTX), while our Long-Term Buy List has 34% in this low-risk bond fund.

Transports and financials feel pressure
Was the recent bounce just a bear-market rally? Or were investors beginning to discount an eventual turn in the economy? The Dow Transports typically do a good job of answering such questions, and recent action has been discouraging. After rallying 728 points from the Nov. 20 closing low of 2,988.99, the Transports have dropped nearly 600 points since Jan. 6.

Some criticize the Dow Theory’s reliance on the Transports, arguing that it is a mistake to attach such importance to a small-capitalization group that often diverges considerably from the Industrials and broader gauges like the S&P 500 Index.

Such criticisms miss the point, for the Transports are useful precisely because they don’t move in synch with the Industrials. The Transports are highly sensitive to the outlook for the industrial sector, and history suggests making money in the stock market is difficult when the outlook for this sector is deteriorating.

The Transports seem particularly relevant today, as they provide insight on the impact of the credit crunch on the real economy. Global trade flows have dropped sharply in recent months, partly because it has become difficult for exporters and importers to obtain trade financing.

Also worth watching is the financial sector, which has been pressured by expectations of big December-quarter losses. Top officials at the Federal Reserve say more government money needs to be pumped into ailing banks, and investors are increasingly worried that financial business will be lost to the government permanently.

With the primary trend in the bearish camp, a defensive posture remains appropriate. In addition to holding a sizable cash position, subscribers should emphasize shares of companies with strong finances. Attractive names include Accenture ($34; ACN) and St. Jude Medical ($31; STJ).

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