Don't Get Distracted

5/10/2010


The true measure of an investor’s discipline is not the avoidance of distractions, but how he or she copes with them.

Amid headlines of debt contagion in Europe, terrorism, oil spills, war, and looming financial-reform legislation, it takes discipline to focus on the three primary long-term drivers of the stock market — corporate profits, interest rates, and inflation.

Hitting the gas

At the start of January, consensus estimates projected a profit decline of nearly 9% for the S&P 500 Index in 2010. Expectations have risen steadily this year, and the consensus now projects a full-year profit gain of 32%.

With about two-thirds of S&P 500 Index companies having reported first-quarter earnings, the index’s growth rate based on a blend of actual and estimated results is a robust 53%. Profits for the consumer-discretionary, financial, and materials sectors are expected to be up more than 100%.

So far, 78% of S&P 500 companies have exceeded first-quarter profit expectations. If that percentage holds, it would be the second-highest in at least 16 years. Total net income has topped the consensus by 16%, versus an average of 2% since 1994.

The profit picture appears bright, and the market’s other key drivers are doing little to mar the view. Core inflation excluding food and energy has been under 2% since late 2008 and declined in each of the first three months of 2010. Based on the Federal Reserve’s preferred inflation measure, core inflation was 0.6% for the March quarter — the lowest reading since 1959.

The Fed’s target federal funds rate has remained at 0% to 0.25% since late 2008, and in April the Federal Open Market Committee said it plans to keep the rate low “for an extended period.” Yields on 10-year Treasury bonds have retreated to the middle of an 11-month range, dropping from nearly 4.0% in early April to less than 3.6%.

Conclusion

A near-term move to 10,340 to 10,772 on the Dow Industrials would not be surprising. But with the Dow Theory in the bullish camp and trends in corporate profits, inflation, and interest rates mostly favorable, we’re inclined to view pullbacks as buying opportunities. For now, we recommend holding 5% to 15% of equity portfolios in a short-term bond fund while emphasizing reasonably valued stocks with genuine growth potential, such as Varian Medical Systems ($56; VAR).


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