Averages under pressure


The stock market has suffered its first substantial decline since March, reflecting profit-taking and concerns that the world economy is not recovering. Whether the decline turns into a significant secondary correction may hinge on June-quarter results, so near-term profit warnings will be crucial.

With the move to new lows in March the last confirmed signal under the Dow Theory, holding a sizable cash position seems prudent. As a partial hedge, about 30% of our recommended equity portfolios are in Vanguard Short-Term Investment-Grade ($10.20; VFSTX), a relatively low-risk bond fund with a yield of 3.8% and a year-to-date return of 7.7%.

Insider selling
Investors have no shortage of reasons for taking some money off the table. The equal-weighted S&P 500 Index gained more than 57% from March 9 to June 10, pushing the valuation of the typical U.S. stock to mildly attractive from downright cheap. Consensus profit estimates continue to fall, adding to the upward pressure on price/earnings ratios. And selling by corporate insiders has jumped to the highest level since June 2007.

Meanwhile, while surveys of purchasing managers and consumers have shown improvement, concrete signs of strengthening in the economy remain scarce. In a June 24 statement, the Federal Reserve said economic data since April suggests the “pace of economic contraction is slowing.”

Historically, a slowing rate of contraction has not been enough to sustain a bull market. But stocks tend to move in advance of the economy, and periodic pullbacks are part of all bull markets. Still, if the averages do suffer a significant correction, you are likely to hear pessimists argue that the bear market has resumed — and optimists argue that such pullbacks are a healthy development. As you sort through these arguments, market history and the Dow Theory may be of help:

• In general, significant moves retrace one-third to two-thirds of the preceding move. Based on this rough rule of thumb, moves to 7,300 to 8,050 on the Dow Industrials and 2,565 to 2,985 on the Dow Transports would qualify as significant pullbacks. Moves well below those ranges would suggest the declines are not merely pullbacks in a new bull market, and moves below both the March lows of 6,547.05 and 2,146.89 would confirm that the bear market remains intact.

• In secondary reactions, the movement counter to the primary trend tends to be fast and furious. Rallies in a bear market are apt to be violent and erratic, as are declines in a bull market.

• In a bull market, stocks tend to hold up amid bad news — and rally on good news. In a bear market, even good news cannot lift stocks.

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