Dow Theory Turns Bearish

08/09/2010 1:00 pm EST

Focus: MARKETS

Charles Carlson

Editor, DRIP Investor

Charles Carlson, editor of the DRIP Investor, says the famed market-timing theory just flashed a “sell” signal, so he thinks investors need to be more cautious.

Is the market’s primary trend bullish or bearish? For an answer to that question, I generally refer to the Dow Theory.

The Dow Theory looks at the movements of the Dow Jones Industrial and Transportation Averages. So, what is the Dow Theory saying about this volatile market? On June 30th, both the Dow Jones Industrials and Transports fell to significant lows, thus triggering a Dow Theory bear market signal.

To be sure, no market tool, including the Dow Theory, is infallible, which is one reason I do not recommend using [it] in an all-or-nothing fashion. I prefer to consider the Dow Theory in conjunction with other factors, such as the availability of attractive values, when setting the appropriate cash position in portfolios.

Still, after following the Dow Theory for decades, I’ve learned to respect [its] signals and take appropriate precaution when the primary trend flashes bearish, as it did on June 30th.

Given that there are still high-quality stocks available at attractive valuations — and corporate America, as a group, continues to put up better-than-expected corporate profits — I’m inclined to temper my bearishness somewhat. Still, I would prefer to err on the side of caution at this point. Thus, I feel comfortable playing defense with a cushion of 20% to 30% in cash/fixed-income investments in an “all-equity” portfolio.

I would apply that same 20% to 30% cash plug proportionately across more “balanced” portfolios. For example, if you typically limit the stock exposure in your portfolio to, say, 60%, you might want to ratchet down the exposure to 42% to 48%.

While playing defense at this time makes sense, investors should never ignore the opportunity to upgrade portfolios if quality stocks decline.

[Meanwhile,] the 15% tax rate on dividends (along with a similar rate on long-term capital gains) is set to expire at the end of this year. Marginal tax rates are set to rise as well in 2011, with the highest tax bracket jumping to 39.6%.

The upshot is that if the current tax rates are not extended, investors in the highest tax bracket could lose roughly 40 cents out of every dollar in dividends to taxes. That is nearly three times the current amount, or a tax increase of 164%.

Of course, the argument for raising taxes on investments is you have to have the rich pay their “fair share.” Our nation has big deficits, and one way to whittle down those big deficits is to eliminate a free ride for those very rich, dividend investors. You know, people like you.

My guess is that you don’t feel like the “very rich.” And regular folks generally get swept up in the quest for greater “tax fairness.”

When asked what scares me the most about this market, right at the top of my concerns are rising taxes on investments. Basic math says that if you boost taxes on investments, you reduce expected after-tax returns. And if you reduce expected after-tax returns, asset values will adjust downward.

Subscribe to the DRIP Investor here…

Related Articles on MARKETS