Underlying Values On The Rise


Charles Dow, the first editor of The Wall Street Journal, believed bull markets have three phases. In the first phase, when business conditions are poor, value-minded investors accumulate positions. In the second, the improvement in business conditions and profits becomes increasingly apparent, lifting company values and drawing in more investors. Finally, in the third stage, the public is heavily involved and share prices discount not only present conditions but future possibilities.

Dow wrote the editorials that laid the foundation for the Dow Theory between 1899 and 1902, but his three-part taxonomy seems timely given the 93% gain in the Dow Industrials over the past 26 months. On average since 1896, bull markets in the Industrials have seen 68% advances over 32 months. However, two of the bull markets since 1974 lasted more than six years.

Obviously, much depends on the length of the second phase, when profits and underlying company values are rising. Rather than blindly applying historical norms, Dow Theorists prefer to look for concrete signs that a bull market has reached the speculative third phase:

The Dow Industrials and Dow Transports. When both averages reach significant highs, underlying company values are probably improving. When one or both averages fail to surpass previous highs, a bull market may be running out of steam. Encouragingly, both averages reached fresh highs within the past month.

Profits. Earnings and earnings-estimate trends can help determine whether underlying company values are improving. Encouragingly, March-quarter profits for the S&P 500 Index are on track to be up 19% from year-earlier levels, better than the 12% consensus when earnings season began April 8. Over the past month, favorable revisions have lifted expectations for full-year 2011 and 2012.

Valuations. The S&P 500 Index trades at 13 times expected year-ahead earnings, below 20-year norms. The median stock in the S&P 500 trades at 17 times trailing earnings, slightly below the norm of 18 since 1990. While the typical U.S. stock is not cheap, neither is it clearly overvalued.

Sentiment. Sentiment among newsletter editors is not encouraging, as the spread between bulls and bears is near 20-year highs. Also discouraging: Inflows into mutual funds, especially aggressive small-company funds, surged in the March quarter.


While sentiment indicators are worrisome, the weight of the evidence suggests stocks are rising because underlying company values are rising — not because of a speculative fervor. For now, our buy lists have 9% to 11% in a short-term bond fund.

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