Evolution is a powerful force. Over centuries, our need for survival has led human societies to evolve from groups of cave-dwelling hunters and gathers into our Wal-Mart-shopping modern selves.
Just as societies must evolve to survive, so must investors. As a value investor, one of my most basic tenets is that all assets are attractive at the right price. Early in my career I openly espoused the theory that the direction of the broad market did not matter. If we could find the right stock at the right price, gains would come our way.
Throughout most of the past decade, this approach worked wonderfully. However, as most of us learned last year, the world is now a much different place. Previously unimagined events occurred, correlations moved to one, and the belief that the broad market could not take cheap stocks even cheaper became very evident.
As the markets have changed, so have I. Now, I am more attuned to broad market swings and the likely path of stocks over short time periods. While I will never sell a long-term core holding because I believe temporary weakness is on the horizon, I will use the expectation of weakness to hedge my portfolio's total risk. In the brave new world, we are all market timers now.
Examining the current underlying trend, I expect short-term weakness to be followed by a resumption of the bull move higher. The rally off the March and July lows has been sharp and violent. During such rallies, a pause is always needed to consolidate gains and eliminate some of the overly bullish sentiment that always chases moves higher.
When one considers long-term market swings, the powerful move off the March low has yet to reclaim 38% of the total bear market decline. Typically, bear market rallies will reclaim anywhere from 50 to 65% of the prior decline before topping out and moving lower. Such a rally would pull the Dow Jones Industrial Average (Dow) toward 11,000-a large distance from the recent close.
Comparing the larger picture against the current backdrop, I remain convinced prices will head higher and the current rally will not top out until the Dow is above 10,500. However, the shorter term offers a different reading.
A benefit of rallying markets is prior peaks must be topped to show continued strength, and prior lows must offer support. Last Friday, the Dow showed technical weakness as it opened at a new high and then closed sharply lower. This created a classic reversal that was followed by Monday's 186-point decline. Now we train our eyes on how far this reversal will take us to determine if the decline is a simple consolidation or something more ominous.
A logical resting point for the Dow is 9,000. Were we to bounce higher from this level, it would indicate that higher prices await us. However, should the Dow fall below 9,000, investors must fix their eyes on 8,860. It was from this level that the Dow launched higher on July 23. Were that price to offer little support, a retest of 8,200 will quickly follow as the entirety of the July rally is surrendered.
For investors there are a few different approaches to take. The more conservative should watch 9,000 and 8,860. If prices bounce higher from there, it indicates the rally will continue, while failure at these levels would push us toward the sidelines. For the more aggressive, buy at these support levels and be prepared to close positions at small losses should the support eventually fail. With prices destined to resume their rally, I will look to buy weakness. However, we should be aware of the signs that would prove us wrong and be prepared to change our minds if the facts change as well.