Good News Not Good Enough

2/8/2010


Stocks have been choppy, with mostly upbeat December-quarter results failing to lift stock prices. Near-term trading may hinge on economic news, as investors remain worried about the pace and sustainability of economic recovery. For now, a partially hedged posture seems appropriate; we’re holding 20% to 25% of equity portfolios in Vanguard Short-Term Investment-Grade ($10.69; VFSTX), a relatively low-risk bond fund.

Consensus estimates surpassed

The Commerce Department estimates that the U.S. economy, as measured by gross domestic product, grew at an annual rate of 5.7% in the December quarter. While much of the increase reflected inventory restocking, real final sales rose at a better-than-expected 2.2% rate. On average, economists now expect GDP growth of 2.7% in 2010 and 2.9% in 2011.

December-quarter corporate profits have been even more impressive. With roughly one-half of S&P 500 Index members having reported, 78% have exceeded consensus profit expectations, according to Thomson Reuters. Total S&P 500 profits are on track to jump 206% from the year-earlier quarter, or 15% excluding the financial sector.

Two-thirds of S&P 500 components have exceeded consensus revenue estimates, and total revenue is expected to be up about 7%. While revenue is likely to rise just 2% excluding financials, the turn toward positive revenue growth bodes well for continued earnings growth. Indeed, analysts have been raising their growth forecasts for 2010.

Yet stocks have slumped. Since Alcoa ($13; AA) kicked off earnings season on Jan. 11, the Dow Industrials have dropped 3.5%. The Dow Transports have slumped 7.5%, as economically sensitive groups have suffered more than most.

Conclusion

Investors are worried about persistently high U.S. unemployment, massive government budget deficits and the potential for tax increases, the Obama administration’s efforts to rein in the financial sector, and Chinese moves to slow their economy.

While bull markets always climb a wall of worry, we suspect genuinely bad news that calls into question the sustainability of the economic recovery would be enough to trigger a significant secondary correction.

To hedge that risk, we’re holding 20% of 25% of equity portfolios in short-term bonds. With the remaining 75% to 80%, we’re emphasizing high-quality stocks with attractive valuations, including BMC Software ($38; BMC), IBM ($126; IBM), and General Mills ($71; GIS).


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