Earnings Test Rally's Strength


After the biggest five-week rally in more than 70 years, stocks entered earnings season vulnerable to disappointment. The market’s ability to weather bad profit reports will be crucial, as a substantial near-term retreat could undermine a budding recovery in investor sentiment.

With the Dow Theory in the bearish camp and quality stocks available at cheap valuations, a defensive yet opportunistic posture remains appropriate. Subscribers should hold 30% to 40% of equity portfolios in a short-term bond fund, watch the averages, and look for opportunities one stock at a time.

Significant rally
After dropping 6,511 points from May 2 to March 9, the Dow Industrials rebounded 1,536 points. The Dow Transports fell 3,346 points from June 5 to March 9, then rebounded 842 points. The Industrials gained 23% from March 9 to April 9, while the Transports surged 39%.

While neither average retraced even one-third of the preceding decline, the duration and extent of the rebounds suggest the rallies since March 9 should be viewed as significant. So, the state of the Dow Theory is fairly clear. When the market corrects, breakdowns below the March 9 closing lows of 6,547.05 and 2,146.89 would reconfirm the bearish trend. If the market corrects and at least one average can hold above the March 9 lows, the closing highs reached in the current rally will represent the trigger points for a bull-market signal.

Against that backdrop, the reaction to March-quarter earnings could be crucial. Better-than-expected reports could trigger another round of short-covering and panic buying, putting more distance between the averages and the March 9 lows. Worse-than-expected reports could put the March 9 lows back in play, especially if companies indicate that expectations for an earnings recovery in late 2009 and 2010 are unduly optimistic.

Consensus estimates now project a 37% year-to-year decline in total earnings for the S&P 500 Index for the March quarter — well below the 12.5% decline that was expected on Jan. 1. The ratio of negative profit warnings to positive warnings for the March quarter is an unusually high 4.7-to-1 among S&P 500 Index companies, according to Thomson Reuters.

While March-quarter results are widely expected to be weak, earnings reports and the related guidance are likely to dominate trading in coming weeks. As always, the market’s reaction to earnings season deserves close attention. A favorable reaction would suggest that expectations for an earnings recovery over the next 18 months remain intact.

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