News Analysis date published New: 
Wednesday, January 26, 2011 - 13:00
New Date created: 
Thursday, August 15, 2013 - 11:09
New Date last updated: 
Wednesday, January 26, 2011 - 13:00

Get Ready for a Market Pullback

Wednesday, January 26, 2011 - 1:00pm

Exactly one quarter ago, with the Dow Jones Industrial Average hitting 11,000, I asked a simple question: will the next move be to 12,000 or back to 10,000? Well, the bulls ruled the day, and the market has tacked on another 9% gain since then. This rally seems to never end.

The sharp rise off the March 2009 bottom made clear sense. So many good companies were selling at such low valuations that you needed to ignore the noise and simply pick the best apples from the barrel. Yet the most recent move in the market is a bit more puzzling.

The markets were approaching fair value last spring, then pulled back and have since gone on to post another impressive rally. The Dow has rallied roughly 20% in the past five months, which works out to be a nearly 50% annualized gain. At a time where you should expect 10% to 15% annual market gains -- at best -- we should be truly grateful. We should also take a more cautious posture. Here's why.

Factors behind the move
As I noted, the market would potentially rally for three reasons: earnings season would likely be impressive, companies would likely start to discuss fresh hiring and capital spending plans, and the Federal Reserve's massive new easing program would provide ample fuel for rally.

Let's break these down to see where we stand...

1. Earnings
Fourth-quarter results have started rolling in and while they've been impressive thus far, the next few weeks are likely to be more sobering, according to Zacks Investment Research. They've been decent, but not quite as impressive as the really impressive results we saw in the second and third quarters of 2010.

According to Zacks Investment Research, revenue growth for the 350 companies in the S&P 500 that have yet to report are expected to show a cooling off. Sales for companies in the S&P 500 rose 9% sequentially in the third quarter, but are expected to be flat for the companies that have yet to report. These companies may show some upside to forecasts, but the big top-line gains of 2010 are clearly winding down. Excluding financial stocks, sales growth likely hit 8.6% in 2010, but should slow to 6% in 2011 and 5% in 2012.

Sales growth in recent quarters had been accompanied by an impressive expansion in profit margins, which enabled earnings to grow very quickly in 2010. Most of those gains have already been made as companies have completed their streamlining initiatives -- so bottom-line gains are set to slow. Companies in the S&P 500 likely boosted earnings by a collective 44% in 2010, though that rate should slow to 12% in 2011 and just 9% in 2012.

Year S&P 500 projected profits ($B) Year-on-year gain
2009 $544.3
2010 $782.6 44%
2011 $907.0 12%
2012 $1,001.0 9%

The S&P 500 now trades for about 12 times projected 2012 profits, which would mark the first time in several years that the market multiple is higher than the earnings growth rate. Not cause for an alarm, but not cause for a further rally either.

2. Hiring and capital spending
I had been predicting a big focus on growth plans during fourth-quarter conference calls, marked by rising targets for hiring and capital spending. But it's just not happening. Admittedly, earnings season isn't even half way over yet, but for the companies that have reported thus far, the tone remains cautious.

If a pickup in hiring and capital spending fails to materialize soon, economists will likely need to temper their growth forecasts. Right now, most economists predict rising GDP, perhaps in the 3% to 4% range in 2011. Those forecasts assume at least a moderate reduction in unemployment and a moderate boost in corporate and consumer spending. Yet we remain in a vicious cycle. If we saw real movement on this front, I would instantly become more bullish on stocks.

3. The Fed's easing program
Market strategists generally assumed that the Fed's decision to buy back bonds (and thus free up capital) in a program known as QE2 would likely add roughly $1 trillion in fuel to the stock market (which is higher than the stated $600 billion program due to leverage effects). Trouble is, the total value of the S&P 500 has already risen by nearly $1.5 trillion. So we may be on borrowed time on this. Remember that what the Fed giveth, it will eventually have to taketh away. Any move to start unwinding the QE2 program (and withdraw liquidity from the economy) probably won't happen in 2011, but anticipation of such an eventual move could turn into a market drag in 2011.

Earnings season has about three more weeks to run its course. Large companies have weighed in thus far, and we'll soon hear from mid-sized companies and then from smaller companies. You need to stay tuned to see what's happening at these firms as well. If many of them announce expansion plans for 2011, then the market will have a legitimate reason to rally higher. But right now, that doesn't seem to be happening.

Action to Take --> After a furious 22-month run, it's time to be more cautious. If you've had any massive winners that now sport price-to-earnings (P/E) ratios well above where they were a year or two ago, then you should think about harvesting profits.

But you can sit tight and hang on to those stocks that have barely budged. Any further market gains are likely to benefit stocks that have not yet been in rally mode as investors try to find any remaining bargains. Taking profits now enables you to raise cash to put back to work if the market decides to consolidate the recent sharp gains. At this point, Dow 11,000 -- or lower -- looks like a more attractive entry point than 12,000.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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