Quality Stocks Gaining Traction


With improving economic data countering European debt-contagion fears, stocks have been volatile. The Dow Transports have rebounded to new rally highs, led by renewed strength in airfreight and railroad stocks. The Dow Industrials, hampered by relative weakness in large financial and health-care stocks, is about 1.5% below its Nov. 5 closing high of 11,444.08.

A close above 11,444.08 would be encouraging, as it would reconfirm the bullish primary trend under the Dow Theory. Also encouraging would be a breakout in the large-company S&P 500 Index, which has failed to match recent new highs in the more economically sensitive S&P Midcap 400 and S&P SmallCap 600 indexes.

A near-term failure to close above 11,444.08 would be a noteworthy development. But nothing in the Dow Theory says the Industrials and Transports need to reach new highs at precisely the same time, and recent action in cyclical stocks and the broad market suggests the outlook for corporate earnings growth remains favorable.

Moreover, investors appear to be rotating into the higher-quality stocks favored by Dow Theory Forecasts. Among S&P 1500 stocks, top-ranked stocks based on Quadrix scores for Earnings Estimates, Financial Strength, Momentum, and Quality have outperformed the average stock since Sept. 30. Top scorers on Value have underperformed only modestly, so top Overall scorers have outperformed handily.

Plan of attack

Near-term market action will likely be dominated by news related to U.S. employment, the sovereign debt crisis in Europe, and China's efforts to contain inflation. But interest rates represent a wild card for the year ahead, as much of the bullish case hinges on the valuation of stocks relative to today's low bond yields.

Yields on 10-year Treasury bonds have moved to a four-month high near 3.0%, up from 2.4% in early October. If yields move to 3.5% or even 4.0% because of stronger-than-expected economic data, stocks are likely to deliver solid returns. But a jump in yields caused mostly by inflation fears would be bad news, so investors should watch the Transports and other cyclical stocks for real-time feedback on the outlook for the economy.

For now, our recommended portfolios have 16% to 18% in Vanguard Short-Term Investment-Grade ($10.83; VFSTX), a bond fund that has dropped 0.7% from its Nov. 3 high. With the remaining 82% to 84%, we're emphasizing Quadrix leaders with operating momentum and attractive valuations. Top picks include Aflac ($52; AFL), Altera ($35; ALTR), and Apple ($311; AAPL), all with Overall Quadrix scores of 97 or higher.

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