Watch The Averages

9/13/2010


The economically sensitive Dow Transports have gained nearly 8% since Aug. 24, reflecting hope that the U.S. economy will muddle through without a double-dip recession. A breakdown below the July lows of 9,686.48 in the Dow Industrials and 3,906.23 in the Dow Transports would confirm the bearish trend. Rebounds above this year’s respective highs of 11,205.03 and 4,806.01 would suggest the primary trend is bullish. For now, our cash position remains at 25% to 30%.

Near-record profits

Corporate profits have surged near record highs. Interest rates have dropped close to record lows, reflecting mild inflation and expectations that the Federal Reserve will remain on the sidelines indefinitely. Yet stocks remain mired in a trading range, with sentiment broadly apathetic and trading listless.

While trading volumes are likely to pick up as summer winds down, a breakout from the recent trading range seems unlikely without greater clarity regarding the economic outlook. Consensus estimates project slow but steady U.S. economic growth through 2011, and such an environment should support continued growth in U.S. corporate profits.

According to the corporate profit measures prepared by the Bureau of Economic Analysis, which tend to track reported profits for publicly traded companies, seasonally adjusted corporate profits have increased sequentially for six straight quarters. On a year-over-year basis, second-quarter profits were up 39% and were only 1% below the quarterly peak reached in the third quarter of 2006.

Year-over-year, reported profits for the S&P 500 Index were up 58% in the March quarter and 38% in the June quarter. While growth is expected to slow, consensus estimates project double-digit growth for S&P 500 profits through the second quarter of 2011. The S&P 500 Index now trades at 12 times expected year-ahead profits — at the low end of a 25-year range.

Conclusion

If the U.S. economy muddles through and avoids a double-dip recession, corporate profits are likely to remain on an uptrend. Remember, today’s soft labor market is not only depressing consumer demand but also limiting employee-compensation costs. While we intend to examine economic data and earnings news closely in coming months, the stock market is likely to move in advance of the economy. So, until the averages break below the July lows or above this year’s highs, a wait-and-see posture seems appropriate. For new buying, new Focus List selections Advance Auto Parts ($56; AAP) and Apple ($258; AAPL) represent top picks.


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