Averages show some resilience


Stocks have been volatile, reflecting mixed earnings news and the daily crapshoot that is financial services. The Dow Industrials have held up relatively well amid some potentially bearish news out of the financial sector, and the Dow Transports are trading within 8% of the all-time high reached in June. For now, a mostly invested, wait-and-see posture seems appropriate. As a partial hedge, hold 15% to 20% of equity portfolios in a money-market or short-term bond fund.

Low expectations
As always, it is a stock’s reaction to an earnings report that reveals whether a company has met expectations. While the same holds true for news of any sort, it is sometimes difficult to determine when non-earnings news hit the market.

Still, when Merrill Lynch ($26; NYSE: MER) announced plans to sell more than $30 billion in mortgage-related debt securities for 22 cents on the dollar, take a $5.7 billion write-down, and sell new shares that will dilute existing stockholders by about 38% — and saw its stock finish 8% higher on the day — it was a clear sign that expectations for the company were low.

Similarly, the financial sector has rallied despite seemingly weak June-quarter results. For the financial companies in the S&P 500 Index that have posted June-quarter results, total earnings have been 87% below consensus estimates, according to Thomson Financial. Yet the financial sector has rallied roughly 20% since earnings season began.

Whether low expectations will be enough to keep the financial sector afloat will be watched closely, as the broad market has been hard-pressed to make much headway when financials are falling. Even sideways trading in the group might be enough for the major averages to build on recent gains, but a move below the July 15 lows in the banks and brokerages would be bearish.

Also worth watching are consumer stocks. Apart from the financials, the consumer-discretionary sector is expected to post the worst year-to-year profit decline in the June quarter. Surveys indicate that Americans remain extremely grim regarding the economy, but traders are betting that the pullback in gasoline prices could take some pressure off the consumer.

Despite some notable June-quarter shortfalls, the percentage of all U.S. companies exceeding consensus profit expectations is running ahead of historical norms. More important, the broad market’s reaction to the results has been decent. A move below the July 15 closing lows in the Industrials and Transports would be a reason to consider raising more cash, but a 15% to 20% cash position seems adequate for now.

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