Wall Street Caught Flat-Footed

8/20/2012


Blue chips have advanced fairly steadily since early June, putting the Dow Industrials within 1% of the May 1 closing high of 13,279.32. But the Dow Transports, still moving mostly sideways, remain more than 4% from their February high of 5,368.93. Closes above both those highs would reconfirm the bullish primary trend under the Dow Theory.

Without confirmed new highs, some uncertainty regarding the primary trend will remain — as will the potential for a bear-market signal with breakdowns below the respective June lows of 12,101.46 and 4,847.73. For now, we intend to hold 10% to 15% of our buy lists in a short-term bond fund.

Tough question

While Wall Street has viewed the market's rally with a jaundiced eye all year, skepticism regarding the advance since late July has been particularly high. That's partly because Wall Street strategists were more bearish than at any time in the last 27 years at the end of July, according to Merrill Lynch. Also, earnings estimates have eroded as stocks have advanced. Consensus estimates now project earnings for the S&P 500 Index will be down 2% for the September quarter, down from the 3% increase expected on July 1, according to Thomson Reuters.

Why are the Dow Industrials and S&P 500 Index near this year's highs (and within 11.5% of all-time highs) when profit-estimate trends are so negative, especially considering the stubbornly slow pace of U.S. growth and the mostly discouraging economic news from Europe and Asia? The easy answer, at least for the bears, is that investors are being irrational. But smart investors are reluctant to think they are smarter than the market, so it makes sense to consider the bullish arguments. Among the more cogent:

The stock market looks forward. For some of the U.S. investors who control the most money, including pension funds, the primary challenge is generating decent inflation-adjusted returns over the next 10 or 20 years. Doing so with bonds is nearly impossible given today's yields. So, unless such investors are very pessimistic on the long-term outlook for U.S. corporate earnings, many will be looking to shift from bonds into stocks.

The news has not been all bad. The July employment report and recent initial jobless claims suggest U.S. employers do not expect a near-term drop in demand. The housing market continues to heal, and commercial lending is picking up.

Investors are afraid to fight the Fed. Federal Reserve Chairman Ben Bernanke has made it clear he will pursue additional stimulus if the economy slows down considerably. Creating money to buy bonds may not do much for the economy, but Bernanke's money-printing has been good for stocks.


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