Rebound Stalls On Profit Worries


A stronger dollar, mostly downbeat economic news, and a jump in profit warnings have eroded near-term earnings expectations, helping put the averages within a few bad headlines of the June 4 closing lows. A move below those lows — 12,101.46 on the Dow Industrials and 4,847.73 on the Dow Transports — would put the Dow Theory in the bearish camp.

For now, we intend to watch the averages while holding about 10% to 15% of equity portfolios in a short-term bond fund. If both averages close below the June 4 closing lows, our bond-fund exposure will be increased to about 25% — and our hotline will be updated.

Valuations and sentiment

A breakdown below 12,101.46 and 4,847.73 would represent a textbook bear-market signal. On the upside, a breakout above 13,279.32 and 5,368.93 would represent a bull-market reconfirmation.

The big question for investors is how drastically to respond to a bear-market signal. Our fairly modest expected response, which calls for keeping up to 75% of equity portfolios in stocks, depends importantly on two key conclusions, both of which will be tested this earnings-reporting season:

Stocks, especially big ones, are fairly cheap. The median stock in the S&P 500 Index trades at 15.1 times trailing earnings, below the norm of 17.7 since January 1990. Only 13% of month-ends since January 1990 had a lower median P/E. From a long-term perspective, the capitalization-weighted S&P 500 Index trades at 15 times trailing earnings, below the norm of 17 since 1946, according to data maintained by Prof. Robert Shiller of Yale University.

But Shiller prefers to use 10-year average earnings, and on that measure the S&P 500 Index trades at a 9% premium to the norm since 1946. Trailing one-year earnings are unusually high relative to 10-year average earnings, partly because of huge losses in the financial sector in 2008 and 2009. Also, many argue that recent earnings have been inflated by an unsustainable jump in profit margins.

Stocks are not cheap based on price/sales ratios, partly because companies are squeezing more earnings from each dollar of sales. If near-term results lend credence to the bears' argument, and investors conclude that profit margins are headed lower, price/sales ratios and share prices will come under pressure.

Investors are already fairly pessimistic. Mutual-fund outflows and sentiment surveys point to a high degree of skepticism, suggesting investors are somewhat prepared for bad news. Estimates for June-quarter earnings have been falling since mid-April. But stocks continue to react harshly to profit disappointments, and the market's reaction to June-quarter results merits close attention.

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