New Highs for the Dow Jones: A Perfect Reason to Stay Away

by James Brumley | March 5, 2013 2:03 pm

The news is inescapable. The Dow Jones Industrial Average reached new all-time intraday highs today (and was set to break its closing mark) … and although the media certainly had a field day with it, traders barely even batted an eye while breaking through the ceiling.

When you take a step back, though — and that’s admittedly a very big step back — one has to wonder just what’s driving the rally. Is there really any fundamental justification for this effort, or are stocks going higher just because they’re going higher?

The latter can happen more often than you might think.

Valuation Reality Check

From a momentum perspective, there’s plenty to be excited about. A fresh batch of buyers has been inspired today as the Dow Jones Industrial Average has moved past its prior all-time high of 14,198 (reached on Oct. 9, 2007) with Tuesday’s surge to 14,286 … and counting.

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There was no direct news spurring the rally, though indirectly, February’s strong reading from the Institute of Supply Management’s service index suggested the economy is in better shape than some had presumed. It was a flimsy reason, but enough of one for the bulls to glom onto at the time.

Yet, it’s tough to believe the market doesn’t know the risks of buying into the market en masse here in the shadow of the Dow’s 13.8% run-up since mid-November. The sequester takes $85 billion away from the government’s spending plans for 2013, fourth-quarter earnings were a major disappointment, China just put the brakes on its fast-growing real estate market, and Europe’s economic recovery remains questionable.

None of it mattered today.

The influx of buyers isn’t exactly getting a bargain, though. Thanks to the big move, the Dow Jones Industrials are trading at an average of 15.8 times their trailing income … and that’s not operating income, but GAAP income. On the more-commonly watched operating basis, the Dow’s P/E measure is at least a little higher. Both are above the long-term average for the Dow, and for perspective, the trailing P/E a year ago was only 14.5.

Translation: These blue chips aren’t exactly cheap right now, and there’s not much to suggest the future looks exceedingly great.

Sometimes, however, valuations just don’t matter. If traders see an index going higher, that can be enough of a reason to take off your investing hat and put on your trading hat.

Getting Technical

To give credit where it’s due, the Dow Jones Industrial Average walked past the big psychological resistance line of 14,000 like it wasn’t even there. It also pushed past the resistance level around 14,040 quite nicely late last week. Today, it marched past the prior peak of 14,198 without a second thought.

It’s all bullish stuff, and it took no time at all for investors to act on the “buy new highs” mantra. That’s not a star traders will want to blindly hitch their wagons to, though.

Standard & Poor’s Sam Stovall explains why. The head of S&P’s research arm notes that in prior instances of re-reaching prior highs, the market tacks on an average gain of only 3% above the prior peak price before starting what he describes as a “meaningful decline.” In each of the past 11 cases, it took two months or less for the market to lose anywhere from 5% to 20% of its value. The good news is none of those prior pullbacks from new highs started a bear market. The bad news is more than half of those post-new-high peaks led to pullbacks of 10% or more.

If the current new-high scenario for the Dow plays out like the typical new-high scenario, the Dow is apt to reach somewhere around 14,623 before the end of April, at which time it will slide back to something around a value of 13,160.

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It wouldn’t be hard to believe, either. A 14% rally doesn’t leave much room for a lot of upside, even when the news is good. The news of late has been anything but good, suggesting this whole rally effort is on borrowed time.

The Dow also is now 8.2% above its key 200-day moving average line. That’s an excessive separation that just doesn’t last long. See, the market can do “crazy” for a while, but not forever.

The Last Word

A bearish view here simply because of the Dow’s milestone moment is clearly a minority opinion, and an unpopular one at that. But the fact the consensus is so bullish right now might well be the sign that the last of the would-be buyers are on board.

Indeed, with so many profits ready to be locked in, the move into all-time-high territory is more likely to start that profit-taking wave than it is to actually pull enough new buyers in to keep this rally going. That’s certainly how it has worked in the past, anyway.

Be careful of the euphoria here.

Source URL: https://investorplace.com/2013/03/new-highs-for-the-dow-jones-a-perfect-reason-to-stay-away/

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