Profit worries weigh

10/27/2008


Despite signs of a thaw in the credit freeze, stocks have been unable to build on their mid-October bounce. With near-term volatility likely as earnings are released, you should be alert to opportunities — and quick to sell stocks no longer among your favorites. For now, keep 25% to 35% of your stock portfolio in short-term reserves.

Earnings outlook
The Dow Industrials lost 4,600 points from May to October, so even a typical bear-market rally is likely to attract attention. While it is possible the bear market ended in mid-October, the Dow Theory will remain bearish unless three things happen.

-First, the Industrials and Transports must stage significant rallies. With a typical one-third to two-thirds retracement of the May-to-October drop, the Industrials would reach 10,000 to 11,500. The Transports would reach 4,250 to 4,875.

-Second, both averages must correct, with at least one average holding above its October closing low.

-Third, both averages must rebound to close above the highs reached in the post-October rallies.

For the Industrials and Transports to stage significant near-term rallies, earnings reports may need to provide some grounds for optimism. The September quarter is expected to be the S&P 500 Index’s fifth consecutive quarter of lower year-to-year earnings, the longest such streak since 2002. Excluding big gains in energy and sharp declines among financials, S&P 500 earnings are expected to be up slightly.

Compiling consensus estimates for individual companies, the consensus for S&P 500 Index earnings per share is about $97 for 2009, up from $81 for 2008. Some Wall Street strategists, who tend to take more account of the outlook for the economy, predict earnings will be down at least 10% to $73.

While the S&P 500 is modestly valued relative to historical norms at 12 times the $73 per share expected by strategists, the index is downright cheap at nine times the $97 expected by industry analysts. To the extent the guidance provided with third-quarter results provides some clarity on the 2009 outlook, the impact on share prices could be substantial.

As always, it will be market’s reaction that reveals whether results and guidance have met expectations. The same holds true for individual companies, so look for attractively valued shares rallying on strong third-quarter results.

Conclusion
While a move to 10,000 to 11,500 on the Dow Industrials would not be surprising, such an advance should be viewed as a bear-market rally.


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