Earnings Arrive Amid Gloom

7/12/2010


Stocks remain choppy heading into earnings-reporting season, with worse-than-expected economic reports pressuring stocks of all stripes. Shares of economically sensitive companies have been hit particularly hard, and the Dow Transports now trade more than 15% below the high reached in early May.

While we intend to remain opportunistic in looking for attractive stocks, our recommended cash range is being widened to accommodate this week’s downgrades. As a partial hedge, subscribers should hold 25% to 35% of equity portfolios in a money-market or short-term bond fund like Vanguard Short-Term Investment-Grade ($10.73; VFSTX).

Positive profit trends

Amid widespread talk of a double-dip recession and scattered predictions of another depression, U.S. companies stand poised to deliver robust June-quarter results. Consensus estimates project 27% year-to-year earnings growth for the S&P 500 Index, with growth expected to exceed 20% for the consumer discretionary, energy, financials, materials, and technology sectors.

Total revenue for the S&P 500 Index is expected to be up 9%, reflecting double-digit growth in the energy, health care, materials, and technology sectors.

Based on historical precedent and estimate-revision trends, earnings seem likely to exceed consensus estimates. According to Blooomberg, analysts are raising estimates for U.S. companies at the fastest pace since 2004. S&P 500 Index profits for full-year 2010 are expected to be up 34%, an improvement from the 27% gain expected on March 29.

For the June quarter, the number of positive profit warnings has nearly matched the number of negative warnings. Historically, negative warnings have outnumbered positive warnings by a 2-to-1 ratio, on average.

As always, the forward guidance companies provide with their results will be crucial. That is especially true today, as many bears believe profit estimates have simply not caught up to economic reality. With investor sentiment unusually pessimistic and many stocks oversold on a near-term basis, positive earnings guidance could be enough to spark a sharp near-term bounce.

Conclusion

Our recommended cash position depends on the opportunities available in individual stocks and the market’s primary trend under the Dow Theory. While quality stocks are available at attractive valuations, the recent move to significant lows in the Dow Industrials and Dow Transports suggests a bigger-than-normal cash position is appropriate. Especially attractive stocks include Intel ($19; INTC) and Lubrizol ($79; LZ).


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