4 Questions Only the Market Can Answer

07/25/2012 10:45 am EST

Focus: MARKETS

Richard Moroney

Editor, Dow Theory Forecasts

This earnings season, combined with Europe's financial twists and turns, makes this a time for investors to watch movesments carefully and act quickly when necessary, writes Richard Moroney of Dow Theory Forecasts.

The averages have been choppy, with downbeat global economic news countered by interest-rate cuts overseas and hopes for additional stimulus from the US Federal Reserve.

With June quarter earnings season in full swing, near-term market action could prove telling. For now, we intend to watch the averages while holding 10% to 15% of equity portfolios in a short-term bond fund and looking for opportunities one stock at a time.

Decision Time
Every earnings season is crucial, but June-quarter reports could be especially important. operating results should answer, at least in part, several questions central to the stock market's year-ahead prospects:

  • Have profit expectations come down enough?Economic reports have disappointed consistently over the past three months, and consensus profit estimates for the June and September quarters have declined. Yet the consensus still calls for S&P 500 Index earnings to show year-to-year growth of 13% for the December quarter, so the guidance provided with results will be crucial. As always, the market’s reaction will be the ultimate test of whether companies truly surpass expectations.
  • Will profit margins hold up?For more than a year, bears have been calling US corporate profit margins—which remain near all-time highs—unsustainable. But wages remain under pressure, and the recent drop in energy and other commodity prices also bodes well for margins.
  • How bad are things overseas?Economic conditions in Europe have deteriorated considerably over the past three months, as have expected growth rates in China and other developing nations. Overseas weakness figures prominently in the rash of June quarter profit warnings, but earnings releases and conference calls will offer the first comprehensive look at the slowdown’s effect on US companies’ overseas operations.
  • Is the primary trend bullish or bearish?If solid results trigger a rally above this year’s highs of 13,279.32 in the Dow Industrials and 5,368.93 in the Dow Transports, the bullish primary trend would be reconfirmed under the Dow Theory. With a breakdown below the June lows of 12,101.46 and 4,847.73, the primary trend would be bearish.

Conclusion
Subscribers should pay close attention to the market’s reaction to earnings news, especially if the averages break out of their recent trading range. The same holds true for individual stocks, and investors should be quick to sell companies that no longer rank among their favorites because of a worsening earnings outlook.

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