Discouraging Market Action


Stocks remain under pressure, with both the Dow Industrials and Dow Transports hurt by concerns about Europe’s debt-plagued economy and China’s efforts to slow its growth. While recent market action has been discouraging, we are reluctant to raise cash aggressively, for four main reasons:

The Dow Theory has yet to issue an unambiguous sell signal. A bear market is confirmed when, after one or both averages fail to penetrate previous high points, both averages close below significant low points. Significant lows mark the end of significant secondary corrections, which typically retrace one-third to two-thirds of the preceding advance over three to 12 weeks.

Some viewed the corrections to May 7 as significant, which would mean the Dow Theory turned bearish when rallies from those points faltered and the May 7 points were violated. But the pullback to May 7 was just two weeks on the Industrials and four days on the Transports, and the rebounds off the May 7 points comprised just three trading days. The averages staged minor bounces from lows reached May 27, but the bounce in the Industrials was less than 3%.

All things considered, we’re inclined to view the entire pullback from this year’s highs as a single correction. So, our plan is to defer judgment while we wait for meaningful rebounds from the lows established in the current correction. If those rallies fail to reach new highs and the averages then move below the lows of the current correction, the Dow Theory will be in the bearish camp.

A near-term bounce would not be surprising. Investor sentiment has become considerably more pessimistic since early May, and the percentage of NYSE stocks trading above their 200-day moving averages has dropped sharply. Both indicators, while very fallible, bode well for the possibility of a near-term market bounce.

Stocks are reasonably valued. The S&P 500 Index trades at roughly 13 times expected 2010 earnings — modest relative to 20-year norms and very modest relative to bond yields. The median U.S. stock is similarly cheap, and high-quality stocks are unusually cheap relative to low-quality stocks.

Our stock-picking system is working. Since late April, stocks with high Overall Quadrix® scores have outperformed handily, reflecting continued outperformance by good Value scorers and much-improved results from Quality and Financial Strength scores. Our buy lists have also outperformed, as our recommendations are not riding on expectations of rapid growth in the global economy. With doubts regarding growth likely to linger, our growth-at-a-good-price approach seems well positioned.

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