Averages At 13-Month Highs


The Dow Industrials and Dow Transports reached fresh closing highs, surpassing those reached in mid-October and prompting more than a couple of questions among our subscribers. For purposes of this page, two stand out:

Q The primary trend is regarded as bullish when the Industrials and Transports are reaching significant highs, so how can the Dow Theory still be in the bearish camp when both averages reached 13-month highs this month?

A We’re not convinced the highs reached this month are significant. While the Transports retreated 11% from the Oct. 20 closing high, the pullback in the Industrials was less than 4%. The pullbacks of May and June were more substantial, but neither retraced even one-third of the rebounds from the March lows.

For a return to the bullish camp after a rebound from bear-market lows, the averages need to suffer significant corrections and then rebound above the highs reached prior to the corrections. Otherwise, there would be nothing to distinguish a bear-market rally from the first advance in a new bull market. By definition, an investor who waits for a Dow Theory bull-market signal before buying will always miss the first significant advance of a new bull market.

Typically the first significant advance does not bring a 59% increase in the Dow Industrials, like that seen since March. But typically the preceding bear market does not bring a 54% drop in 17 months. The Industrials dropped 6,511 points from an intermediate high reached in May 2008, while the Transports dropped 3,346 points from an all-time high reached in June 2008. Typical one-third to two-thirds retracements of those drops would put the Industrials at 8,717 to 10,887 and the Transports at 3,262 to 4,378.

With both averages in those ranges, the rebounds since March are within the parameters of bear-market rallies. However, the duration of the rebounds far exceeds the three weeks to three months of a typical bear-market rally. One way or another, today’s ambiguity will be resolved when the averages suffer significant corrections.

Q Why is Dow Theory Forecasts holding about 25% of its equity portfolios in a short-term bond fund?

A Our stock-market exposure depends on our interpretation of the Dow Theory and the opportunities available in individual stocks. Partly because the Dow Theory has yet to provide an unambiguous bull-market signal, we’re holding about one-fourth of our equity portfolios in Vanguard Short-Term Investment-Grade ($10.64; VFSTX) as a hedge. However, we’ve added to our stock-market exposure as the extent and duration of this year’s rally has reduced the likelihood of a breakdown below the March lows. Also, we’ve added new recommendations as opportunities have presented themselves.

While we realize that many subscribers would prefer a more definitive, all-or-nothing approach, we think our results speak for themselves. We rank among a select group of newsletters that has outperformed the market over the past five, 10, and 15 years. Our Focus List — helped by a gain of 33.7% on a fully invested basis and a 14% return for Vanguard Short-Term Investment-Grade — has gained 27.1% so far in 2009 versus 22.9% for the S&P 500 Index.

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