Bear Market is Dead

According to Dow Theory, two recent events have confirmed a new bull market in stocks:

1)		During the week of January 29th, the Dow Jones Industrial Average set a new record high. During that same week the Dow Jones Transportation Average and the Dow Jones Utility Average also established new record highs. A confirmation of new highs among those three averages signals a bull market.

2)		The second event that occurred was February 20th when all three averages hit new highs on the same day. This action is called a “confirmation of a confirmation” that the bear market is over and that a new bull market has been born.

What amazes us at Market Watch is that none of the mainstream financial media picked this up and said anything about it. There was a small paragraph in the February 5th Wall Street Journal that pointed out “the Dow Jones Transportation Average bettered its peak of last May 9th. This confirmed the new high in the industrials.” They did not point out this was the final step indicating that, according to Dow Theory, the bear market is over. We are now in a bull market.

It is of great concern that this market bears a striking resemblance to the 1998 and 1999 bull market where price earnings ratios on the Dow Industrials averaged 22 times earnings (as they are right now), and the dividend yield was a paltry 1.8% (where it is now). As we remember, 1998, 1999 and 2000 were bonanza years in the stock markets with values way out of proportion to average stock market values over the last 100 years. Average Dow values of 14.5 times earnings on the industrials and an average yield of 4.2% were out the window.

Is there a new standard of values? I dunno. When all of the indicators are in bull mode, as they are now, it does not pay to fight the bull. The trend is your friend.

It does pay to be cautious, however. We need to be aware of the following things, and we need to be aware that any one of them unraveling might very well cause the market to go tumbling;

1)		This is the 8th month in a row that the Dow has set a new record high. In the last 100 years, consecutive records of more than 8 months have occurred 14 times. The longest run was 12 consecutive months without at least a 10% correction in the market. So somewhere in here, history tells us to look out for a sell-off of the stock market. In a bull market, we call these sell offs “buying opportunities”.

2)		Currently money is moving out of the bond market and into the stock market which is why the stock market is going up. If bonds become increasingly unattractive, the United States will not be able to finance its $750 billion trade deficit. At that point, the only way to renew an interest in bonds is to increase interest rates. If interest rates are increased to attract bond buyers to finance our aforementioned trade deficit, and our $650 billion federal spending deficit, the effect will be to increase demand for bonds. That is likely to cause a ripple in the stock market by moving money out of the stock market and into the bond market. Continued reduced demand in the stock market could cause the Dow Jones Industrials to begin to revert to mean values of 14.4 times earnings and a dividend yield of 4.2%.

3)		All currencies are measured against the value of gold. It is felt that gold is tremendously undervalued. With gold going up in value (currently over $675 an ounce), gold is still 20% below its 1982 high of $850 an ounce. With inflation, gold, at $850 an ounce in 1982, would now be equal to more than $2600 an ounce. If the stock market has been inflated to its current values and stock certificates are an intangible item, why wouldn’t gold, a tangible item, set new records, too? Particularly in view of the fact that currently all central banks are creating new money at a rate averaging 10% in a world economy that is growing at less than half that rate? This imbalance has heretofore created inflation. Over the long run, the value of gold’s purchasing power remains the same. A good men’s suit in 1930 cost one ounce of gold ($20), and a good men’s suit still costs one ounce of gold.

4)		As Market Watch pointed out in the article published in February, whenever the Dow is at 21 times earnings, or higher, the average ten year return on the Dow, with dividends, is only 4.8% per year. A treasury bond now yields around 5% with no risk.

What to Do

The Dow Jones previous record of 11,722 in 2000 should be adjusted for inflation. In that event, the Dow would exceed 14,000 points. Today it hovers around 12,300 points, so theoretically, the market must add about 1,700 points to make investors even. This bull market is therefore still under priced, and it has a ways to go on the upside. The next target for the Dow is in the low 14,000s.

Even in overpriced bull markets there are still stocks that are buys. Market Watch has enumerated many of them in the last several issues that are A-rated stocks, selling well below their historical price earnings ratio, and supporting a dividend in excess of their historical yield. In a rising market, stocks that pay high current dividend yields can be expected to increase in price with both (1) the market, and (2) as demand for income increases. It behooves the investor to purchase well known companies in an effort to minimalize risk. The market is already priced for risk, so those stocks that have the least risk attached to them are known as value stocks, as mentioned above. They are the stocks that should be added to a portfolio in an overpriced, but rising, bull market. An excellent service for these value stocks, which also includes the top 350 dividend paying stocks in this country, is IQ Trends (www.iqtrends.com). IQ Trends principle founder, and owner, Geraldine Weiss, retired a few years ago, but the system she perfected and successfully used for more than 30 years is still in tact.

Another excellent source to help one refine this thinking is a new book recently published by well thought of Wharton Professor Jeremy Siegel entitled “The Future For Investors”. His book argues the same set of principles he has been setting forth in 30 years of teaching. He writes: “investing for growth is the wrong way to go unless those growth stocks can be purchased at good prices. Buy growth companies that have low price earnings ratios, and that have a history of making investors partners by paying dividends, and frequently increasing those dividends, over a long period of time”.

How do we protect ourselves?

1)		Buy mostly A-rated, well known, and dominant companies in their industry that are selling for a low historical price earnings ratio and which pay an historically high dividend yield.

2)		Don’t allow oneself the temptations of “hot tips”, uncovered options and other risky financial gimmicks that can drastically reduce the value of your portfolio in a short period of time. Be disciplined and hit singles every time at bat. Forget trying to hit home runs. The home run we swing for, and strike out, may require so many singles to recover that we could be set back for years!

Conclusion

The market sell off on Tuesday, February 27th, was indicative of what can happen in a high risk market like this one. Regardless, according to Dow Theory, we are in a bull market. Until reversed, the upside target is still the inflation adjusted low 14,000s on the Dow Industrials. A conservative approach will probably provide for both better sleeping and better long term returns.

Caveat Emptor.
George Rauch
March 2, 2007

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