Dear MoneyNews Reader:

Over the last couple of week’s I’ve become accustomed to watching headlines telling me that the Dow Jones industrials was at a record high. And then it wasn’t, but then along came another really.

After days and days of watching, the Dow finally mustered up the strength to close above the January 14, 2000 peak. For the subsequent two days it built upon the breakthrough and finally added 200-points to the record high.

Now that the euphoria has subsided, many investors are asking "where next?" for the Dow.

We could consider that question in terms of interest rates, the economic cycle, commodity prices, earnings and parallel stock markets.

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The economy is clearly coming off the boil. Demand is falling and labor market improvements are becoming incremental rather than accelerating.

Interest rate increases aimed at stemming the rising inflationary tide have done their job. Yet still there’s always a flip side to that coin. The housing market at first cooled, then noticeably slowed and is now rolling over. How deep and how lasting the impact, no one seems to know yet.

But of course the trauma has been felt in shares of homebuilding companies, several of which have halved in price this year.

Following the 2000 Dow peak and the subsequent onset of recession, homebuilder stocks became the darling of investors as it slowly became apparent that the Fed was fueling a housing boom. Let’s call that the onset of the economic cycle as it faces the transition from boom to bust.

That begs the question of whether we are once again in that same position. Interest rates have been lifted to cool a hot economy. Earnings across corporate America will grow by a single-digit pace for the first time in 19 quarters starting in 2007.

So what is the record high in the Dow industrials really telling us?

Is it predicting a recession ahead? Is it signaling that growth has slowed so much that the Fed will be forced to spur a new boom via the housing market as it slashes monetary policy?

While the equity markets are supposed to discount the future stream of corporate earnings, there’s something that doesn’t stack up with this bullish tone just as the slowdown is building.

While the Dow industrials index is possibly the world’s best-known measure of stock prices, it represents just 30 companies. The S&P 500 index is broader yet has peaked this year some 12% below its 2000 all-time high.

The even broader Wilshire index covering all of corporate America is also 8% off its peak. Meanwhile the Nasdaq composite index representing technology stocks has recovered least and stands 53% below its peak.

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Technology will take many more years before returning to what were bubble valuations. This week Google announced the purchase of YouTube.com for $1.65 billion. Some commentators remarked that this was reminiscent of the dot.com era when extreme valuations were given to worthless companies.

Let me remind you that back then Google wasn’t even in public ownership, but that now it is earnings billions. The dot.com years weighed heavily on companies that bled red ink. Companies that found out how to make a dollar from the Internet have flourished while losers sank into oblivion.

To understand better the prospects for the Dow we need to revisit Dow Theory. Basically stated, when the economy is firing on all cylinders the industrial sector should be booming and as such the transport sector will be busy delivering and trucking shipments around the country.

In investment terms, the rise in the Dow industrials is confirmed by a rise in the Dow transports average.

The picture above doesn’t support the view that Dow Theory is kicking into confirm the bull market. In order to see that, according to Dow Theorist Richard Mahoney at the Dow Theory Forecast, the Dow transport index would need to close above the 2006 high at 4998.95. Without it the market will fail under its own weight.

In other words, while the rally in the Dow will remain significant, a failure to confirm the bullish tone in the transports will set the tone for a bear market, according to the theory.

Mr. Mahoney makes a prescient observation when it comes to a valuation call. He distinguishes between the capitalization weighted S&P 500 and the equal weighted S&P 500 index.

You can actually buy a mutual fund that invests equal weights in the index rather than favoring the performance of the biggest components. That approach has been proven to be more profitable than biasing larger stocks.

Measuring the price to earnings multiple of the S&P on the former cap-weighted basis, which is what we hear repeatedly in the press, the index trades at the lower end of its ten year range. At a multiple of 18 times trailing and 15 times forward earnings, that’s inexpensive.

But on an equal weighting basis, Mr. Mahoney observes that the average PE ratio is in line with the 10-year norm. While in broader indices including midcap and smallcap stocks, average PEs are modestly above 10-year norms.

Simply stated any increase in the average stock prices here, at a time when earnings growth is slowing, will tip them towards an above average valuation on a PE basis.

Mr. Mahoney explains the spillover in the rise of the Dow in the fact that investor sentiment hasn’t yet to become overly optimistic. He notes that the percentage of bullish newsletters lags that of eras of exuberance during the last three years when stock markets were at their peaks.

Like most of us, Mr. Mahoney is at an impasse when it comes to the impact from homebuilding on the economy. He notes that building-materials suppliers have cut forecasts in sympathy with builders. Yet both groups have risen since July indicating the fact that Wall Street may have already discounted enough bloodletting.

"Or perhaps with mortgage rates down considerably since June, could Wall Street’s worst fears for housing be overdone? Time will tell," notes Mr. Mahoney.

This week, we also heard two important pieces of news that inform us as to how the Fed is interpreting data and how its thought process is moving.

The minutes from its most recent meeting sent shivers through the bond and interest rate sensitive market this week. The minutes showed that the central bank was fretful that inflationary pressures would not ease fast enough.

The interpretation in the bond market was that the Fed is not thinking about a rate cut anytime soon. The minutes put recent Fed officials’ comments into better perspective. Fed newcomer, Charles Plosser stated last week that it might even be in the best interests of the economy to raise rates sometime soon.

The Beige Book was released just as the Dow reached a fresh record on Thursday.

The report covers ground-level surveys from the Fed’s 12 regional districts as it examines business sentiment and prospects.

The report showed that despite a widespread cooling from the housing market, consumer demand picked up. Half of the Fed’s 12 regional districts reported ‘mixed or moderate’ demand while four claimed respondents noted a firming in demand. Two noted a ‘cooling’ in demand.

Investors are starting to see a soft-landing for the economy.

In conclusion, despite a slowing economy and its implications for corporate profits, investors seem keen to keep loading up to the gills on equities.

For now the buying spree goes unchecked and my take is that unless the transportation index confirms the rally, I agree with Dow Theory that we’ll fall back into the mire before the end of the year.

Have a great weekend!