Primary Trend Turns Bearish


Stocks have slumped on discouraging economic news, pushing the Dow Industrials and Dow Transports below their June lows and putting the Dow Theory in the bearish camp. Reflecting four downgrades this week, the stock-market exposures of our buy lists are at 78% to 79%.

Textbook bear-market signal

After a move to multiyear highs this spring, both the Industrials and Transports suffered significant corrections to reach the June lows. Then came a retest with an unconfirmed move to new highs in the Transports, followed by a move below the June lows in both averages.

Tellingly, the averages rendered a verdict after some crucial news developments, including a resolution to the U.S. debt-limit impasse and the release of June-quarter results. Both have been overshadowed by poor economic news. Also, while a near-term U.S. default has been averted, long-term concerns regarding the creditworthiness of debt-heavy U.S. and European governments are mounting.

Overall June-quarter results appear solid, with more than 70% of S&P 500 Index members exceeding consensus profit expectations through Aug. 2. But forward guidance has been underwhelming, and several bellwethers have suffered sharp sell-offs after reporting.

Sentiment and valuation

While we don't believe in timing the market in an all-or-nothing fashion — and plenty of quality stocks are trading at reasonable valuations — history suggests a bear-market signal should not be taken lightly.

How much lower are the averages likely to go? The Dow Theory cannot answer that question. But at bear-market lows investor sentiment tends to be very depressed and stocks tend to be very cheap. Neither condition seems true today, though stocks are cheap relative to bond yields.

As shown below, the median U.S. stock has an earnings yield, or trailing earnings/price ratio, in line with 15-year norms. But bond yields are unusually low. If you expect inflation and bond yields to remain low — and you expect corporate earnings to remain on at least a modest uptrend — stocks are arguably cheap right now.

But the breakdown to new lows in both averages suggests the majority money opinion has turned bearish on the investment outlook, so we are not inclined to take the consensus forecasts of economists at face value. For now, our plan is to hold 20% to 25% bond-fund positions in our equity portfolios while looking for buying and selling opportunities on a stock-by-stock basis.

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