Earnings Trigger Bounce

8/2/2010


Amid solid June-quarter earnings reports and signs of improvement in the European debt crisis, U.S. stocks have rebounded. For now, as a partial hedge, our Focus List and Buy List have 28.0% in Vanguard Short-Term Investment-Grade ($10.77; VFSTX). Our Long-Term Buy List has 31.0% in this relatively low-risk bond fund.

Earnings report

With more than one-third of S&P 500 Index companies having released June-quarter results, about 78% have exceeded consensus profit estimates and about 69% have exceeded consensus revenue estimates, according to data from Yardeni Research published in The Wall Street Journal.

According to Bloomberg, profits among S&P 500 companies are expected to climb 34% in 2010 and 17% in 2011, which would represent the fastest two-year growth since 1995. Yardeni Research says year-ahead profit estimates for the S&P 500, S&P Midcap 400, and S&P SmallCap 600 indexes have climbed since the beginning of earnings season, reaching the highest levels since October 2008. The S&P 500 Index trades at less than 15 times trailing earnings. Since 1954, the index’s average trailing P/E is 16.5, according to Bloomberg.

Dow Theory analysis

With profits growing and stocks reasonably valued, the missing ingredient for investors is favorable action from the averages. Some argue that because the Transports did not close below their February low in the recent sell-off, the recent rebounds above the June highs in the Industrials and Transports represented a bullish signal. This argument represents a fundamental misunderstanding of the Dow Theory.

The February lows remain significant if one views the entire decline from this year’s highs as a single correction. But such a view would mean the relevant high points are the April and May highs of 11,205.03 and 4,806.01. The June highs would not qualify as significant under this view because the rally leading to those highs would be an insignificant bounce that was part of the April-to-July correction.

For the June highs to be relevant, the preceding rally needs to be viewed as significant. And if the preceding rally is viewed as significant, then the July breakdown below the early-June lows was enough to put the Dow Theory in the bearish camp.

As we see things, a rally above 11,205.03 and 4,806.01 would suggest that the decline from this year’s highs should have been seen as a single correction, that we were too quick to shift into the bearish camp. A breakdown below the early July lows of 9,686.48 and 3,906.23 would reconfirm the bearish trend.


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