Industrials On The Verge


After moving within 1% of three-year highs and a bull-market reconfirmation under the Dow Theory, the Dow Industrials have retreated on heightened concerns regarding U.S. employment and the European debt crisis. For now, we're sticking with our three-part plan:

Watch the averages. A close above the April high of 12,810.54 in the Dow Industrials would confirm recent new highs in the Dow Transports — and signal that the primary trend remains bullish. With a failure to close above that level and breakdowns below the respective June closing lows of 11,897.27 and 5,060.59, we'd view the primary trend as bearish.

As a partial hedge, hold 9% to 10% of equity portfolios in a short-term bond fund. Depending on the opportunities available in individual stocks, a close above 12,810.54 would likely prompt us to lower our bond-fund exposure. With a bear-market signal, our bond-fund exposure will be increased to 20% immediately — and our hotline will be updated with specific instructions.

Look for opportunities one stock at a time. Emphasize attractively valued shares of high-quality companies with operating momentum and the potential to exceed consensus expectations. The typical U.S. stock is not particularly cheap — or expensive — relative to historical norms. But the typical stock's valuation is attractive relative to interest rates, and shares of many large companies seem truly cheap. More important, we are still finding high-quality growers trading at modest valuations.

Looking ahead

The status of the Dow Theory is clear. The multiyear highs reached this spring were clearly significant, as were the four- to six-week corrections to the June lows of 11,897.27 and 5,060.59. Because the Industrials have retested but so far failed to close above their April high of 12,810.54, the averages are positioned for a potentially classic nonconfirmation and bear-market signal. Of course, a mere 2.5% rally to new highs in the Industrials would reconfirm the bullish primary trend — and make the June lows nearly irrelevant under the Dow Theory.

What's less clear is how much you should adjust your portfolio based on recent market action. For our money, given the Industrials' proximity to new highs and the availability of attractively valued stocks, we're comfortable letting things play out with cash at 9% to 10% of equity portfolios. A bond-fund position of 20% may be too low if we get a bear-market signal, especially if near-term earnings news is discouraging. But, with both averages at least 5% above the June lows, we should have a little time to consider June-quarter results and the market's reaction as we consider our strategy.

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