Answers Are Written In The Profits

11/21/2011


With Europe headed for a potential spin-out and the U.S. job market stuck in first gear, why are the Dow Industrials and S&P 500 Index trading within 9% of three-year highs?

Probably the best answer to that question can be seen in the nearby chart of earnings for the S&P 500 Index. Both operating and as-reported earnings for the index are on pace to reach all-time highs in the September quarter, surpassing the records set in the June quarter. Also, while expectations for 2012 profit growth have dipped in recent months, consensus forecasts still project broad-based growth. Nine of the S&P 500's 10 sectors are expected to post profit gains in 2012, with growth for the index expected to exceed 10%.

Bears argue that corporate profits are backward-looking, that expectations for 2012 will be cut as analysts adjust their models for the fallout in Europe. Bulls argue that expectations for 2012 already reflect downbeat expectations for the European economy, that gradual improvement in the U.S. economy and continued growth in emerging markets will sustain the advance in corporate profits.

Indeed, recent U.S. economic releases — including better-than-expected October reports for industrial production and retail sales — suggest U.S. economic growth for the December quarter will accelerate from the 2.5% annualized pace of the September quarter. Recent reports also indicate U.S. inflationary pressures have eased, suggesting the Federal Reserve will be in no hurry to tighten monetary policy.

Moreover, argue the bulls, the sluggish U.S. job market is restraining wage pressure and thereby helping corporate profit margins. The percentage of business revenue that went to labor in the U.S. nonfarm business sector reached the lowest level in more than 60 years in the September quarter. As a percentage of U.S. gross domestic product, wages and salaries have dropped to about 44%, down from about 49% in 2000. Over the same period, corporate profits as a percentage of GDP have roughly doubled to about 10%.

Conclusion

While profits are growing and shares of quality companies are available at reasonable valuations, we'd like to see more constructive action from the market averages before committing the bulk of our cash reserves. A breakout above this year's highs in both the Dow Industrials and Dow Transports would suggest the primary trend is bullish, while a breakdown below the October lows would reconfirm the bearish primary trend. For now, our buy lists have 21% to 22% in a short-term bond fund, with the remainder in stocks. For new buying, top picks include Agilent Technologies ($38; A) and DirecTV ($47; DTV).


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