Global growth in question

8/25/2008


Choppy trading seems likely in the near term, and a breakdown below the July lows of 10,962.54 in the Dow Industrials and 4,653.13 in the Dow Transports would represent a bear-market indication under the Dow Theory. For now, watch the averages and hold 15% to 20% of equity portfolios in cash.

Earnings and interest rates
The S&P 500 Index trades at roughly 13 times expected year-ahead earnings, equating to a forward earnings yield of 7.7%. Ten-year Treasury bonds yield 3.8%. Based on the spread between these yields, the so-called Fed model, the S&P 500 Index has seldom been so undervalued.

Critics rightly point out that the Fed model has a poor track record, with especially bad results since 2000. Moreover, argue the critics, the model is providing an especially misleading signal today, since expectations for profits are wildly optimistic.

Profits for the S&P 500 Index have dropped year-to-year for four consecutive quarters, the first time that has happened since 2002. Yet, even though expectations for the U.S. economy have weakened, consensus estimates still project a sharp rebound in corporate profits over the next six quarters.

History suggests consensus profit estimates are probably too high, but the numbers are not as unrealistic as the bears would have you believe. The financial sector has posted losses in the last three quarters, according to S&P’s calculations, and a return to at least modest profitability seems likely. Expectations of a rebound in the consumer-discretionary sector, hurt by huge write-downs at automakers and homebuilders, also appear reasonable.

Outside the financial sector, analysts’ reluctance to cut estimates partly reflects solid June-quarter results. For each sector of the S&P 500 except financials and utilities, at least 65% of companies exceeded consensus profit estimates. For each sector except financials and telecom services, at least 60% exceeded consensus sales estimates.

Much of the recent strength in profits reflects growth in overseas economies. With Europe slowing, investors will be watching closely for additional signs of a potential slowdown in Asia.

Conclusion
Even if consensus estimates are more optimistic than usual, stocks are cheap relative to Treasury bonds. But Treasury bonds may be overpriced. Moreover, the threat of a worse-than-expected global slowdown deserves to be taken seriously.

In addition to watching the averages and holding some cash reserves, emphasize attractively valued stocks with solid operating momentum and bright profit prospects. Top picks include Accenture ($40; NYSE: ACN) and Harris ($53; NYSE: HRS).


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