Crucial Juncture Approaches

1/11/2010


The Dow Industrials and S&P 500 Index reached fresh 15-month highs in the first week of January, while the Dow Transports reached a 15-month high on Dec. 29. All three averages are up less than 5% since Oct. 19, but recent action has been mostly encouraging. The market’s real test will come in the second half of January, when earnings season gets in gear. For now, as a partial hedge against a market correction, we’re holding 20% to 25% of equity portfolios in Vanguard Short-Term Investment-Grade ($10.62; VFSTX), a relatively low-risk bond fund.

Lofty forecasts

Every earnings-reporting season is crucial. But, for at least five reasons, we view the coming weeks as especially important:

With December-quarter results comes guidance for the year ahead, and investors will be keenly interested in whether the lofty consensus forecasts for 2010 profit growth are realistic.

In addition to earnings news, the next few weeks will bring key economic releases related to employment, factory activity, and inflation in the U.S. and overseas. Expectations for the global economy have risen in recent weeks, reflecting solid news out of the U.S. and Asia.

As expectations for the global economy have improved, shares of economically sensitive U.S. stocks have surged. The Morgan Stanley Cyclical Index, an equal-weighted index of 30 large cyclicals, has jumped 11% since Oct. 19. Yet the Dow Transports have lagged, perhaps reflecting concerns about rising oil prices and fuel costs. With prices for crude oil recently moving above the 2009 high of $82 per barrel, the near-term action of the Transports and other cyclicals will be watched closely.

Improving expectations for the global economy have also lifted bond yields, pushing rates on 10-year Treasury bonds to 3.8% from 3.2% in late November. Any move above the 2009 high near 4.0% will attract considerable attention, as higher bond yields and tightening from the Federal Reserve often trigger corrections in the early stages of economic recoveries.

If the market’s advance since March has been a bear-market rally, the averages are approaching potential resistance. A typical bear-market rally retraces one-third to two-thirds of the previous decline. With two-thirds retracements, the Industrials and Transports would be at 10,887 and 4,378, respectively.

Conclusion

While recent action has been encouraging, we are maintaining a wait-and-see posture. We continue to see value in shares of high-quality companies, but we expect most stocks to retreat in a bona fide market correction. Top picks for new buying include Aflac ($49; AFL) and BMC Software ($40; BMC).


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