An Oversold Market Fuels the Rally

03/24/2009 12:05 pm EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, says stocks have been through one of their worst periods ever, and may have more room to go on the upside.

For all intents and purposes, this market has declined for 16 straight months. The previous record for an uninterrupted decline was the nine months following the bombing of Pearl Harbor. A rally, any kind of rally, has been long overdue.

The Dow Jones Industrial Average (DJIA) printed a bear market intra-day low of 6440.08 on Monday, March 9th. Based on the composite cash dividend of $313.93 reported in IQ Trends, the dividend yield for the average reached 4.9%, a mere ten basis points (0.1%) from the second bear market yield objective of 5%. (4% was the first yield objective and 6% would be the third yield objective.)

Historically bear markets will temporarily reverse direction and retrace a significant percentage of the previous leg down. This allows buyers to come in and provide fuel and momentum for the next leg down. In this bear market, there was basically no counter-trend rally after reaching the first bear market yield objective of 4%.

Why did this happen? After the most vicious six-month period in stock market history, stock sellers may have simply sold themselves to the point of exhaustion.

Another clue from Mr. Market that selling, for the present, may have reached an inflection point is the dividend yield on the Dow Jones Utility Average (DJUA). Like its sister average, the Dow Utilities has a long-term dividend yield profile where 6% represents the historically repetitive area of undervaluation and 3% represents the historically repetitive area of overvaluation.

On March 9th the DJUA declined to an intraday low of 287.29 and a dividend yield of 5.7%. Based on its current composite dividend, a yield of 6% would be reached at 274. Technically then, the DJUA has reached historic undervalued levels. The Utilities tend to bottom and top prior to the Industrials.

The last clue that some degree of bottom may have been put in is that at the end of trading on March 9th our Undervalued category exceeded 70% of our select blue chip universe, a level of undervaluation that has been breached only four times since 1966 and has been coincident with market bottoms.

Until the Industrials and Transports exceed their January highs on a closing basis, however, the primary trend remains down. (The Industrials closed above 9,000 in January, while the Utilities posted a closing high above 380—Editor.)

As such, investors need to remain cognizant that there may yet be another leg down toward the 6% dividend yield objective on the DJIA. Equally possible too, however, is that a sustained rally, perhaps as much as several thousand Dow points is in the making. What we do know definitively is that there is tremendous value in individual stocks that may not be seen again for another generation.

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