Dont fear the pullback


Stocks remain under pressure, reflecting concerns about U.S. consumers’ ability to withstand slumping home prices, surging energy costs, and a sluggish job market. Also weighing are renewed concerns about loan losses, as several bellwether bank and brokerage stocks are testing lows reached earlier this year.

Further near-term weakness would not be surprising, but we view the pullback as a correction in an ongoing bull market. With typical one-third to two-thirds corrections of the March-to-May advances, the Dow Industrials would trade at 12,175 to 12,625 while the Dow Transports would trade at 4,725 to 5,075.

The Dow Theory is bullish and quality stocks are available at reasonable valuations, so subscribers should remain opportunistic. Look for buying opportunities one stock at a time, and be quick to sell shares of companies not performing up to expectations.

For now, our recommended cash position remains at 15% to 20%. Our Long-Term Buy List has 17.5% in the Vanguard Short-Term Investment Grade Fund ($10.58; VFSTX), versus 19% for our Buy List and Focus List. Especially attractive picks include Adobe Systems ($42; NASDAQ: ADBE) and Qualcomm ($49; NASDAQ: QCOM).

Charts to watch
With the outlook for the economy more cloudy than usual, near-term action in the averages will be watched closely. As always, Dow Theorists will be watching the Industrials and Transports. If both averages suffer significant corrections, then at least one average fails in an attempt to surpass the May highs, the bullish case will be undermined. In general, significant corrections retrace one-third to two-thirds of the preceding advance over three to 12 weeks.

Also worth watching are 10-year Treasury bond yields, which recently moved above 4.0% for the first time since January. For most of the past 18 months, higher bond yields have typically meant higher stock prices. But that relationship has not prevailed since early May, perhaps because bond yields are now rising on inflation fears rather than expectations of improvement in the economy.

Among sectors to watch, financials and energy stocks deserve special attention. Banks and brokerage stocks are testing the lows reached in January and March, and a breakdown to new lows in these crucial groups would be discouraging. With a further dip in oil prices, a pullback in energy stocks would be expected. But weakness in energy stocks amid renewed strength in oil prices would be bearish, as it would imply that high prices are depressing energy demand and economic activity.

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