Earnings Met With Selling

1/25/2010


Stocks have encountered their first selling pressure of 2010, with investors reacting to early December-quarter reports and efforts to curb bank lending in China. Choppy near-term trading seems likely as earnings are released, and a significant market correction would not be surprising. As a hedge, we recommend holding 20% to 25% of equity portfolios in a short-term bond fund.

Watch the Transports

The Dow Industrials and S&P 500 Index reached new closing highs on Jan. 19. But the Dow Transports have dipped about 3% from their Jan. 11 high, reflecting worries that a tightening in China’s monetary policy will slow global economic growth. Also, a somewhat disappointing earnings report from CSX ($47; CSX) has triggered a pullback in the railroad group.

While the transportation industry represents less than 3% of the U.S. stock market’s value, the group’s near-term price action deserves close attention. The Transports are highly sensitive to the pace of U.S. and global growth, and their 99% rally since March reflected expectations of a much-improved economy in 2010.

On average, the 20 companies in the Transports suffered much sharper profit declines in recent quarters than the 30 Industrials or the 500 members of the S&P 500. Yet the Transports are expected to deliver superior earnings growth over the next year and next five years.

More important, the median stock in the Transports trades at roughly 18 times expected next-year earnings, well above the five-year norm of 14. By contrast, the median next-year P/E is about 14 for the Industrials and 15 for the S&P 500 — in line with five-year norms. If investors conclude the pace of economic recovery does not justify today’s valuations, the Transports could be especially vulnerable to a correction.

Also worth extra attention are the technology and financial sectors, the two biggest sectors by market value. While early earnings reports from these heavyweight sectors have largely met consensus estimates, investors have been selling on the news.

Finally, the health-care sector could be volatile as investors sort through the implications of the surprise election in Massachusetts of a Republican to the U.S. Senate, which has clouded the outlook for pending health-care legislation.

Conclusion

Further near-term weakness in the Transports would heighten the risk of a broad-based market correction. Subscribers should not abandon stocks entirely or sell quality issues merely to lock up profits, but holding 20% to 25% of equity portfolios in short-term bonds seems prudent.


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