The averages discount everything


After a two-day surge to begin December, the Dow Industrials have paused below the November high of 11,444.08, partly because enthusiasm regarding the likely extension of the Bush tax cuts has been countered by sharply higher bond yields.

A close above 11,444.08 would reconfirm the bullish primary trend under the Dow Theory, while a near-term failure to reach new highs would be a yellow flag. For now, our buy lists have 15.9% to 17.3% in Vanguard Short-Term Investment-Grade ($10.80; VFSTX), a relatively low-risk bond fund. With the remainder, we're emphasizing attractively valued shares with solid growth prospects, such as Texas Instruments ($33; TXN).

Rational expectations

The theory of rational expectations argues that economic outcomes do not differ systematically from what people expect, so temporary government policies designed to influence consumer behavior will have a limited impact.

For example, using additional government borrowing to temporarily cut taxes or boost government spending will not provide much stimulus to the economy, because consumers will increase savings to pay for expected future tax hikes.

The fact that many consumers do not take such a considered view is not especially important; what matters is that, on average, consumers look ahead and seek to maximize their wealth. This school of thought, dominant for much of the 1980s and 1990s, was undermined by the mass delusions of the tech-stock boom and the housing boom. If investors and consumers can become so irrationally exuberant, skeptics ask, does it really make sense to assume they have rational expectations?

The skeptics make a good point. But it would be equally unwise to make the opposite mistake, assuming that government policy shifts can create something out of nothing. Likewise, it is generally a mistake to second-guess the verdict of the stock-market averages.

As founding Dow Theorist William Hamilton wrote in 1922, “It cannot be too often repeated that the stock market, while adjusting itself to the unexpected, as in the secondary reactions, is based not upon surrounding conditions but upon what may be expected as far ahead as the combined intelligence of the market can see.”

History suggests that when the Dow Industrials and Dow Transports are in agreement, both reaching significant new highs, the market is anticipating continued improvement in the investment environment. A move above 11,444.08 would not represent an endorsement of the tax plan, but it would signal that the market does not expect the plan to derail the uptrends in corporate profits or stock prices.

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