The Dow has had an exceptional rally this year. It is now up 34 percent since its low in March, and today alone the Dow is up about over two percent. Fueling the rise today was the news that existing home sales were up 3.6 percent in June. Adding to the good news: a slew of positive earnings announcements. But should investors be cautious?
Among the positive earnings announcements, Ford Motor (F) shocked the market by posting a $2.3 billion profit in its second quarter and its stock rose 11 percent. Others, such as Wyeth (WYE), Philip Morris (PM), Qualcomm (QCOM) and Hershey (HSY) all raised their forecasts for the year. AT&T (T) reported a $3.2 billion profit, higher than expected, and that helped the entire telecommunications sector to rise. The energy sector was also up, due to higher oil prices which rose 2.6 percent to $67.11.
Earlier this week, Federal Reserve Chairman Ben Bernanke also told Congress that the Fed will guide the economy out of recession without spurring inflation -- music to the ears of investors.
But smart investors will take the current market euphoria with a dose of skepticsm. There is a good chance that this current rally will not continue and prudence would be wise. Richard Moroney, editor of the newsletter Dow Theory Forecasts, says that the breakout in the Dow Transports above their May high is not a bull market signal. (The Dow Transports is currently around 3,513.) He said that while some could argue that a close above 3,404.11 in the Transports would be bullish, there are many reasons why this would not be the case.
One reason, says Moroney, is because significant advances in the market are often followed by significant corrections. Moroney says that after rallying 2,252 points from March 9 to June 12, the Industrials fell about 653 points to reach 8,146.52 on July 10 -- a 29 percent retracement of the March-to-June rally.
In general, these are not quick corrections either. Significant corrections typically last three weeks to three months -- and one could be coming.
Moroney also points out that the rebound since March, though long in duration, fits within the parameters of a bear-market rally. In a hotline alert he sent to his subscribers today, Moroney says that a one-third to two-thirds retracement of the decline from May 2008 to March 2009 would put the Industrials at 8,717 to 10,887. For the Transports, the equivalent range is 3,244 to 4,341. With both averages at the low end of these ranges, Moroney says that viewing the rebound since March as an uninterrupted bear-market rally makes sense.
Investors would do well to not assume that the worst is over and that it's time to get into the market. More likely, there will be a substantial correction in the months ahead and a fall in stocks. Moroney points out that at 82 percent, the percentage of New York Stock Exchange stocks trading above 200-day moving averages is high relative to historical norms, further suggesting the risk of a correction is high. You've been warned.