The Dow's Back in the Black -- What's Next?

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As I write this, the Dow Jones Industrial Average (INDEX: ^DJI) is back in the black for the year after this summer's roller-coaster ride. What can we expect now?

In the short term, it will be very interesting to see how the second half of the year pans out in terms of corporate earnings. I've been in the camp warning that earnings estimates are too optimistic because they don't account for corporate profit margins at or near an all-time high. These margins will eventually decline, and we may well witness this in the third and fourth quarter.

Estimates are beginning to come down
With nearly all companies in the S&P 500 having reported their second-quarter results, index earnings have beaten estimates by 5.7%. That's a "beat," yes, but it's the second smallest one since 2009; meanwhile, the full-year earnings estimate has fallen to $98 from $99.50 in July.

Over the longer term (seven years or more), the Dow looks poised to generate a return that is lower than U.S. stocks' historical return, but higher than that of the S&P 500 Index (INDEX: ^GSPC) and substantially higher than that of the Russell 2000 (INDEX: ^RUT). Indeed, mega-cap, blue-chip stocks remain relatively cheaper than the rest of the market, with small caps the least attractive segment.

Pick the safe haven asset
Stock pickers can still earn acceptable returns -- the market isn't uniformly overpriced and there are attractive opportunities. Microsoft's (NAS: MSFT) current valuation -- 9.2 times forward earnings before backing out the company's net cash position -- is almost at deep value levels. I submit that it leaves investors with a healthy margin of safety -- the risk of loss on an inflation-adjusted basis (over an adequate time period) looks low. If you put your money into U.S. Treasuries today, that outcome is virtually assured.

In its annual forecasting contest in December, Barron's asked readers to pick a range for the Dow's 2010 total return. I selected 10.1% to 20%, but I'm much less confident than I was then. The third quarter is historically volatile and, given the current macro environment, there is little reason to believe that this year will be any different.

Are you interested in a company that will continue to grow earnings no matter what the U.S. economy does? Find out which stock is "The Hottest IPO of 2011."

At the time this article was published

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