Earnings Lift Stocks

7/19/2010


Stocks bounced sharply in recent trading as Wall Street applauded the first spate of corporate earnings announcements. While the rally is certainly a welcomed event, investors should not lose sight of the fact that both the Dow Industrials and Transports went to significant new lows prior to the latest bounce. For now, as a partial hedge against renewed weakness in the market, 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).

Strong start for earnings

Positive earnings reports from such economically sensitive companies as Alcoa ($11; AA), CSX ($52; CSX), and Intel ($21; INTC) helped fuel a sharp market rally. The Dow Jones industrial Average jumped 7% in just seven trading days after bottoming at 9686.48 on July 2.

To be sure, it is still very early in the corporate earnings season, so it would be dangerous to extrapolate too much from the few earnings reports that have hit the market. While the market’s stellar performance so far in July is a relief from the nasty declines seen during most of the second quarter, investors need to put the recent rally in perspective.

The last major signal under the Dow Theory was a bearish development on June 30, when both the Industrials and Transports fell to significant closing lows.

Keep in mind that secondary reactions occur in both bull and bear markets. Such reactions tend to be abrupt and sharp, but fairly short-lived, typically lasting three weeks to three months and retracing one-third to two-thirds of the previous move.

The Industrials peaked at 11,205.03 on April 26, falling 1,519 points to the July 2 closing low of 9686.48. The recent rally has already retraced more than one-third of that decline. A two-thirds retracement would carry the Dow to the 10,700 level.

Of course, the Dow Theory, like any market indicator, is not infallible, which is one reason the Forecasts does not use the Dow Theory in an all-or-nothing fashion.

Still, after following the Dow Theory for some 64 years, the Forecasts has learned to respect Dow Theory signals and to take appropriate precaution when the primary trend flashes bearish, as it did on June 30.

Conclusion

Playing defense with 25% to 35% cash holdings in an equity portfolio seems to strike a prudent balance between a Dow Theory bear-market signal, the possibility of a strong corporate earnings season driving stocks higher, and the availability of quality stocks trading at attractive valuations.


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