Decision Time For Averages


Helped by strength in shares of companies exposed to overseas growth, the Dow Industrials rallied to all-time highs. The Dow Transports, advancing on strength in airlines, railroads, and FedEx ($206; FDX), moved within 3% of the March 1 all-time high of 9,593.95.

A close above 9,593.95 would confirm the new highs in the Industrials — and reconfirm the bullish primary trend under the Dow Theory. A failure to surpass 9,593.95 would be discouraging, especially if followed by breakdowns below this spring's lows of 20,404.49 in the Industrials and 8,783.74 in the Transports. For now, our buy lists have 92% to 95% in stocks.

The state of the Dow Theory

Three weeks ago, we wrote, "We're not convinced that a break below 20,404.49 would represent a bear-market signal under the Dow Theory, as the decline that brought the Industrials to that point retraced only 22% of the November-to-March advance."

That remains a valid argument, as significant corrections typically retrace at least one-third of the preceding advance. Still, we're increasingly convinced that a break below this spring's lows would be a reason to raise cash, for three reasons.

First, three weeks have passed. While nothing says the averages must rebound to new highs within a certain time, the Transports have now gone 14 weeks without a new high. That suggests the pullback reflects genuine concerns about the sector's outlook, not just a retreat from overbought levels.

Second, the Transports moved to a new post-March low on May 17, closing at 8,783.74. On that date, the Transports had retraced 32% of their June-to-March advance over 11 weeks — a nearly archetypal secondary correction.

Third, the Industrials moved to a new high, and the Transports rallied to within 3% of their March 1 all-time high. There is no doubt that the averages have staged a meaningful retest of the highs. Also, unconfirmed new highs in one average have often been the precursor to a shift in the primary trend.

Have a game plan

Our focus on this spring's lows should not be misconstrued. The rally in the Industrials and Transports is encouraging, especially because industrial stocks and other global cyclicals have participated. Most important, a mere 3% advance in the Transports would represent a bull-market confirmation.

Still, investors should always have a game plan that accounts for both rallies and declines, and the Dow Theory can help put such moves in perspective. On our reading of the averages, the market has reached an important decision point.

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