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Monday, 19 May 2008

How to Tell if a Rally Is Real

In fits and starts, blue-chip stocks have been climbing higher since mid-March. But many market watchers aren’t convinced that the worst of this market storm, which began in October, is behind us.

“This was certainly a market bottom, and a pretty good market bottom,” said Duncan W. Richardson, chief equity investment officer at Eaton Vance, the asset management firm in Boston. “But I don’t know if it was the bottom.”

For that, investors will have to look for signposts in the future — not the past.

For instance, if stocks are rallying on the belief that the economy is indeed on the mend, investors will need to see signs that it is actually strengthening. “There’s been a lot of stimulus put into place, and you’ve got to look for evidence that that’s working,” Mr. Richardson said.

One important gauge will be corporate earnings — namely, profits among companies outside the financial services sector.

“The world has figured out that the financial sector has serious problems, but the assumption is that the rest of corporate America seems to be doing O.K.,” said Ben Inker, director of asset allocation at GMO, an investment management firm in Boston.

While overall earnings of the Standard & Poor’s 500-stock index are expected to fall nearly 6 percent in the second quarter, profits for the nine nonfinancial sectors are predicted to rise nearly 8 percent.

But can investors count on this trend continuing?

“It’s our significant worry that corporate profits in the nonfinancial part of the system are likely to be weak over the next couple of years,” Mr. Inker said. “If we’re right, and corporate profits are going to start to deteriorate outside the financials, it will cause another round of problems.”

Here are some other factors to watch in coming weeks:

SMALL-STOCK PERFORMANCE

An indication that investors are gaining courage after a market scare is a renewed willingness to own speculative assets.

Small stocks generally perform better than large-capitalization shares in the first few months of market recoveries. Since 1979, for example, the median gain for small stocks in the three months after market bottoms, has been 19.6 percent, according to a study by Ned Davis Research. By comparison, big, blue-chip shares have risen more modestly — by 13.6 percent.

Since March 17, the S.& P. 600 index of small stocks has gained 9.3 percent while the S.& P. 500 index of large stocks is up 8.8 percent. Continuing strength in small stocks through June could offer confirmation that this rally is for real. GROWTH VS. VALUE As markets recover from severe downturns, “growth stocks eventually come back into favor,” said Robert E. Turner, chairman and chief investment officer at Turner Investment Partners in Berwyn, Pa.

Because growth stocks are considered a more aggressive bet than dividend-paying value shares, a growth rally is an indication that “the sellers are done selling and the buyers are ready to come in,” Mr. Turner said.

Since mid-March, growth stocks in the Russell 1000 index of blue-chip stocks are beating their value counterparts — but by less than a percentage point. So this indicator is sending mixed signals for the moment.

SENSITIVE SECTORS

If markets are rallying because the economy is on the mend, it stands to reason that the most economically sensitive stocks should fare best after a market bottom.

The two sectors that have historically led market recoveries are technology and consumer discretionary stocks.

On average since 1974, the tech sector has gained 27.7 percent in the three months after a market bottom and consumer discretionary stocks have risen 23.3 percent in the same period, according to Ned Davis.

Since March, technology has been one of the best performers, but consumer discretionary stocks are trailing the overall S.& P. A surge in the consumer sector would be expected, if the market has hit rock-bottom.

STRENGTH OF THE DOLLAR

A climb in the dollar against the euro for the remainder of this year would suggest that the Fed was nearly done trimming interest rates and that the economy was truly on the mend.

A strengthening dollar would also tell global investors that this could be a good time to invest in United States stock markets.

“If people get a double benefit because our markets are rising and our currency is improving,” Mr. Turner said, “it will only add interest in U.S. equities.”

And that, in turn, would provide yet more support for a market rally.

Paul J. Lim is a senior editor at Money magazine.

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