What Does Dow Theory Say?

11/25/2015 9:00 am EST

Focus: STRATEGIES

Richard Moroney

Editor, Dow Theory Forecasts

After a major decline that ended in August, the Dow Industrials and Dow Transports staged sharp rallies into September, then retreated but held above the August lows. From there, both averages rebounded to surpass the September highs, observes Richard Moroney, editor of Dow Theory Forecasts.

Based on that description, the averages have charted a textbook bull-market signal. However, we see several reasons to take this signal with some skepticism.

Most obviously, the textbook is describing a signal for a new bull market, which by definition follows a bear market.

But the Dow Industrials were only 14% below all time highs at the August closing low of 15,666.44, while the broader S&P 500 Index (SPX) was down just 12% from its record high.

The Dow Transports were down 19% from the December 2014 all time high and investor sentiment by some measures reached bear-market levels in August. Still, it seems a big stretch to label the decline that ended in August a bear market.

It seems an even bigger stretch to say that stock valuations reached bear-market levels in August. Based on trailing price/earnings ratios, the average and median for stocks in the broad S&P 1500 Index did not even get down to 20-year norms.

Today, while valuations are not extreme, they more closely resemble what you’d expect in the late stages of a bull market. The median stock in the S&P 1500 Index trades at roughly 19 times trailing earnings, about 8% above the norm since the index’s 1994 inception.

Based on our breakdown of S&P 1500 stocks on trailing P/E ratio, the story is largely the same: Stocks are not outrageously expensive, but they are more expensive than cheap. About 18% of S&P 1500 stocks have P/Es below 14, fewer than the norm of 25% since 1994.

The terror attacks in France have added a near-term wild card to an already jumbled outlook. While we view the primary trend as bullish under the Dow Theory, we don’t have a high degree of conviction in that call. For now, our advice comes in three parts:

  • Of the portion of your portfolio committed to equities for the long haul, hold 81% to 84% in the stocks on our buy lists. Put the remainder in a short-term bond fund with low expenses and no redemption fees.
  • Listen to the averages. A move to all time highs above 18,312.39 in the Industrials and 9,217.44 in the Transports would remove any doubt that the Dow Theory is in the bullish camp. Short of that, we’d like to see moves above the recent respective highs of 17,918.15 and 8,298.58.
  • Look for opportunities one stock at a time. Whether market conditions are placid or turbulent, you should always be looking for new buys.

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