2 Stories More Important Than Headlines

07/02/2012 9:45 am EST

Focus: MARKETS

Charles Carlson

Editor, DRIP Investor

It's easy to be distracted by all the stories that swirl around the markets these days. Stay calm and keep focused on two simple things, and you'll be better off for it, writes Charles Carlson of DRIP Investor.

With the 24-7 news world we live in today, there is always some event making headlines, some occurrence becoming the “Big Story.” What I have found, however, is that such stories tend to distract from what is really important, especially in the world of investments. With that in mind, here are two things I’m watching.

1. Dow Theory Sets Up
As you know, one of our favorite tools for discerning the market’s primary trend—the trend that typically lasts six months or longer—is the Dow Theory. The Dow Theory looks at two things and two things only—the movement of the Dow Jones Industrial and Dow Jones Transportation averages.

The Dow Theory sets up fairly clearly at this time. In a nutshell, the market’s primary trend currently is bullish. Market closes above the previous highs in the Averages (for the Dow Industrials, the important high to watch is the May 1 closing high of 13,279.32; for the Dow Transports, the February 3 high of 5,368.93 is significant) would reconfirm the bullish trend and likely lead to further upside movement.

Conversely, closes in both Averages below their recent correction lows (for the Industrials, the important low is 12,101.46; for the Transports, 4,847.73) would shift the primary trend to bearish. A bearish signal would likely spawn fairly aggressive downside action in the market.

Remember that the Dow Theory uses closing levels, not intraday levels. Also, in order for a signal to be relevant, both Averages must confirm one another.

What will happen: I still see plenty of values in the market. Furthermore, bear markets usually don’t spring from an environment of such rampant skepticism toward stocks that we see today. While the Dow Industrials and Transports will ultimately tell the tale, I think we’ll see a reconfirmation of the bullish trend.

2. Earnings in Trouble?
We will soon be entering corporate earnings season. What is important to watch during any earnings season is not so much the earnings reported, but how stocks react to the earnings.

We’ve all seen cases when a company reports what appear on the surface to be excellent earnings, only to see the stock sell off sharply. The reason—the earnings disappointed Wall Street’s expectations.

Likewise, we’ve all seen times when a company reports what appear to be terrible profits, yet the stock skyrockets. Why? Because profits beat expectations. Stock-market performance is affected greatly by how well aggregate corporate profits beat expectations. And I mean really beat expectations, not just come in with earnings above some consensus number.

True earnings beats usually are accompanied by a positive reaction to the stock price. If I see lots of companies seemingly “beating” Wall Street estimates, yet the stocks fail to react positively to the news, I regard that as a negative for stocks. On the other hand, widespread positive stock reactions to earnings would be especially bullish.

What will happen: My sense is that, because of a lot of fairly lousy economic data coming out in recent months, investors’ expectations on the profit front have declined. Ironically, that’s probably a good thing, since lowered expectations make it easier for companies to beat those expectations. Although there will always be individual companies that disappoint, I think corporate profits in the aggregate will be strong enough to support higher stock prices.

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