US Stocks Clearing Their First Hurdle

Tuesday, July 27, 2010

Company earnings reports are coming in better than expected, and they are causing stocks to jump. This is the test I wrote about in “US Stock Market’s Trend About To Be Tested” (June 29):

“Bearish investors need to tread carefully in this stock market. The very attractive valuations make betting against the market especially risky. The coming second quarter earnings are a significant test for the bears.”

At the same time, the big scares are dwindling (like Greece/Europe, BP’s oil well and Goldman Sachs). Plus, an important lagging indicator is showing signs of improvement: Lending is beginning to climb and even regional banks are reporting improvements.

The focus seems to be shifting to stock valuations – once again.

This earnings period is the first of three hurdles I described in “This Stock Market Decline Is Painful” (July 2):

  • Second quarter earnings reports (mainly, mid-July to mid-August)
  • Wall Street shift in focus to 2011 earnings estimates (early September)
  • Third quarter earnings reports (mainly, mid-October to mid-November)

So, if things are looking up, why aren’t investors cheering? This is a question addressed in “Blockbuster Quarterly Earnings? Yawn.” (The Wall Street Journal, “Ahead of the Tape,” by Kelly Evans, July 26.) The article points out that experts (e.g., Goldman Sachs and Ben Bernanke) forecast slowing economic growth.

The explanation doesn’t end there. After all, slow growth is still growth, and companies are showing an ability to earn a profit in such periods. Other “experts” are using the slowing to produce future scenarios of a disastrous, deflationary double dip. These worst-case scare tactics have been a common characteristic of this stock market. They drove investors out at the bottom and kept them out of the stock market runup.

So, now what? Get out (or stay out) of the stock market? No, for two reasons:

  1. Market valuations are good – even if growth slows. Still concerned about risk of loss? Then think long-term, focusing on the attractive valuations and dividends. The last article concludes with sound advice: “Indeed, companies like Procter & Gamble [PG] and McDonald’s [MCD] may not be the most thrilling names on Wall Street. But with their above-3% dividend yields, they probably offer the best seat for investors to ride out the recovery.”
  2. Investors (institutional and individual) are under-invested in US common stocks. (For example, see graphs at end of article.) This is what gives stocks their attractive valuations – demand is abnormally low. This is a “contrarian” indicator that pays off when investors get interested in, then feeling positive about, US stocks.

So… Don’t let the doomsayers be your investment advisers. Well-financed companies are reporting good earnings, accompanied by positive outlooks. Could they be wrong? Of course. But anticipating the worst is a highly risky investing approach.

THREE GRAPHS SHOWING MUTUAL FUND FLOWS: WEEKLY, MONTHLY AND CUMULATIVE



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