Rally Showing Signs Of Age

8/3/2009


The averages have paused after a two-week rally, as better-than-expected earnings have lost some of their ability to lift the broad market. With earnings-reporting season winding down, economic indicators will increasingly dictate market action.

At some point over the next several months, doubts regarding the global economic recovery are likely to trigger a significant correction. The ability of the Dow Industrials and Dow Transports to hold above the March lows on such a correction — and then rebound above the highs established in the rally since March — will be crucial for Dow Theorists.

While it is certainly possible that the March lows represented a bear-market bottom, we don’t think the averages have proved this to be the case. Without such proof, we’re inclined to maintain a somewhat defensive posture. Our recommended equity portfolios now hold about 32% in Vanguard Short-Term Investment-Grade ($10.31; VFSTX), a relatively low-risk bond fund.

Great expectations

The stock market’s reaction reveals whether quarterly reports have met expectations, and there is no doubt that June-quarter results represented a positive surprise. Since Alcoa ($11; AA) kicked off earnings season on July 8, the S&P 500 Index has gained more 10%, while the S&P MidCap 400 and S&P SmallCap 600 indexes have gained more than 13%.

With one-half of S&P 500 components having reported, 76% have delivered better-than-expected earnings. If that percentage holds up, it would represent the highest full-quarter figure on record, according to Bloomberg data that begins in 1993.

While analysts have raised expectations for 2009 earnings modestly, meeting consensus estimates for 2010 will require huge profit leaps. S&P 500 and S&P Midcap 400 earnings are projected to be up about 26% in 2010, while S&P SmallCap 600 earnings are forecast to surge 47%.

Meeting such projections will require a rebound in the global economy, as earnings continue to trend lower. Only 30% of S&P 500 companies have posted year-to-year profit gains for the June quarter, while roughly 29% have delivered sales gains.

Conclusion

June-quarter results have been encouraging, but companies will be hard-pressed to meet 2010 estimates unless the global economy rebounds. At some point over the next few months, doubts regarding such a rebound are likely to trigger a significant correction. For now, subscribers should hold a sizable position in short-term bonds while looking for opportunities in individual stocks. Hospira ($37; HSP) represents a top choice for year-ahead and long-term gains.


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