Bearish Trend Reconfirmed



The Dow Industrials and S&P 500 Index closed below their November lows, hitting the lowest levels in 12 years. With both the Dow Industrials and Dow Transports reaching fresh multi-year lows, the primary trend is squarely in the bearish camp. Subscribers should maintain a defensive posture, keeping 30% to 40% of equity portfolios in a short-term bond fund.

Trading on fear
If stock markets trade on fear and greed, there is no question what’s driving share prices nowadays. Bank stocks have cratered on fears of insolvency and government takeovers. Transportation and other cyclical stocks have slumped on fears that an unprecedented decline in global industrial activity is likely to worsen. Even consumer-product stocks have suffered, hurt by fears that overseas economies no longer represent avenues for growth.

Beyond sector-specific fears, investors are worried that government bailouts are making things worse, that the nation’s process for dealing with failed companies is broken. Unless companies like General Motors ($2; GM) and Citigroup ($3; C) can fail and be reorganized, some argue, the natural process of economic recovery will be thwarted. Both U.S. and foreign investors are worried that the U.S. government leaders are making things up as they go along, putting out fires without getting to the root cause of the economy’s problems.

U.S. consumers, hurt by huge declines in home prices and share prices, are pessimistic. In February, the Conference Board Consumer Confidence Index reached its lowest level since its 1967 inception, with consumers citing a rapidly deteriorating job market. Consumer spending has slumped, with cutbacks in everything from luxury items to basic household goods.

Good news, bad news
The news does not need to be good for stocks to advance; it only needs to be less bad than what’s reflected in stock prices. With shares of the median profitable company in the S&P 500 Index trading at roughly 10 times trailing earnings, versus the norm of 18 since 1990, a goodly portion of today’s bad news is probably reflected in stock prices. Sentiment surveys and mutual-fund outflows indicate investors are quite pessimistic, suggesting a little good news could go a long way.

Unfortunately, however, the stock market’s price action does not suggest that all the bad news has been discounted. The fact that the major averages could not avoid breakdowns below the Nov. 20 lows — reached amid panic selling — suggests underlying values are still deteriorating. Until the averages begin to ignore bad news and hold prior lows, we are likely to keep a sizable cash position on the sidelines.

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