If the second half of 2008 turns out anything like the first half, keeping your head together could prove a challenge. Avoiding emotional or knee-jerk decisions is easier when you can put headlines in context, so key themes for the next six months are highlighted in the following paragraphs:
The Dow Theory. Divergence between the Dow Industrials and Dow Transports was resolved by a bull-market signal in April, when the Industrials confirmed the Transports by moving to a significant high. But the Industrials have been under pressure since closing at 13,058.20 on May 2, while the Transports rallied to reach an all-time high of 5,492.95 June 5.
So far, recent market action is worrisome but not cause for a shift in strategy. A typical one-third to two-thirds retracement of the March-to-May advance would have brought the Industrials to 12,175 to 12,625. The Industrials have moved below 12,175, and a breakdown well below that level would be cause for concern, especially with a close below the March low of 11,740.15.
Still, it’s worth noting that much of the weakness in the Industrials reflects sharp declines among financial stocks. On June 5, the day before oil prices surged $11 per barrel in one trading session, most sectors of the market were just 1% to 3% below four-month highs. Equal-weighted measures of the market, which have not been hurt as much by the sell-off in financials, closed near year-to-date highs on June 5.
A rebound above 13,058.20 would reconfirm the bullish primary trend. With a failed attempt at 13,058.20, followed by a decline below the lows reached in the current correction, the trend of the Industrials would be down. But such a trend change would need to be confirmed by the Transports, so a bear-market signal is unlikely in the near term.
Oil prices. For most of the past five years, oil prices and the Transports moved higher together, reflecting strong global demand for fuel and transportation services. If oil prices continue to move higher and the Transports stall or move lower, it would suggest that oil prices are now rising on supply concerns.
Corporate earnings. Unless oil prices spike even higher, the U.S. economy seems likely to muddle through without a contraction in gross domestic product. Moreover, U.S. corporate earnings increasingly depend on growth overseas, with an estimated 40% of profits for the S&P 500 Index driven by foreign economies.
Consensus estimates project that June-quarter earnings for the S&P 500 Index will be down 7.3% from the year-earlier period. But profits are expected to be up 7.6% excluding the financials — and 4.4% excluding both energy and financials. If profits outside the financial sector meet or exceed expectations, it would support the bulls’ argument that many stocks are cheap considering the earnings outlook and today’s relatively low interest rates.
Inflation. Rising food and energy prices are undercutting consumer living standards. If inflation and inflation expectations move beyond food and energy, the Federal Reserve may need to raise interest rates aggressively, threatening the economic recovery.
Holding 15% to 20% of equity portfolios in cash remains appropriate. But the primary trend remains in the bullish camp under the Dow Theory, and we are still finding quality stocks trading at reasonable valuations.