September Brings Worry

9/12/2011


September has been the worst month for the U.S. stock market since 1896, with an average monthly loss of 1.1% in the Dow Industrials. In comparison, the average for the other 11 months is a gain of 0.7%.

While nobody knows why September has been such a poor month, among the more logical explanations is that September is when many investors refocus on the full-year outlook for profits — and when companies admit that previous guidance was too optimistic.

That explanation is worth keeping in mind this year, as doubts regarding consensus profit estimates are central to the bearish case. Despite widespread reductions to economic-growth projections, estimates for U.S. corporate profits have held firm.

Consensus estimates for the S&P 500 Index project year-to-year profit growth of 15% for the September quarter and 16% for the December quarter, down only slightly from what was expected on July 1. Full-year 2012 earnings are expected to be up 14.0%, versus the 14.3% expected on July 1.

In part, analysts are following the lead of corporate executives, as profit warnings from U.S. companies have been running below historical norms. Have executives learned there is little to be gained by being among the first to warn on profits? Or are executives still truly optimistic on the profit outlook?

The fact that buying by corporate insiders surged in August is encouraging. But the next month of trading will be crucial, as many expect a surge in profit warnings before the release of September-quarter results.

If investors gain confidence in the profit outlook, the potential for an upward revaluation of the stock market is substantial. The S&P 500 Index is cheap versus historical norms based on trailing 12-month earnings and expected year-ahead earnings. But valuations based on 10-year average earnings are slightly above the 50-year median.

Bears argue profits are cyclical and today's profit margins are unsustainable, so valuing stocks based on one year of near-record earnings is foolhardy. Still, a couple more quarters of robust profit growth are likely to turn some skeptics into bulls.

Conclusion

The near-term reaction to earnings news will be crucial. With breakdowns in the Dow Industrials and Dow Transports below their respective August closing lows of 10,719.94 and 4,221.60, the bearish primary trend would be reconfirmed under the Dow Theory. Moves above the August highs of 11,613.53 and 4,686.96 would be encouraging. For now, we have about one-fourth of our buy lists in Vanguard Short-Term Investment-Grade ($10.72; VFSTX).


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