Great July, but get ready for a market correction

What a month! In July, the Dow Industrials were up more than 8.5 percent, the best month on record since October 2002. The Dow Transports gained more than 10.5 percent for July, and both averages are trading at their highest levels in at least six months.

Have we left the bear behind? We turned to Richard Moroney, editor of Dow Theory Forecasts, to get his perspective on why July was such a good month and whether this could be a positive signal for the market.

Moroney points out that much of the euphoria in July came from good earnings results. Since Alcoa (AA) kicked off earnings season on July 8, the S&P 500 Index has gained more than 10 percent, while the S&P MidCap 400 and S&P SmallCap 600 indexes have each gained more than 13 percent. At month's end, with one-half of the S&P 500 components having reported, Moroney says that 76 percent delivered better-than-expected earnings. If that percentage holds up, it would represent the highest full-quarter figure for the S&P 500 on record, according to Bloomberg data going back to 1993.

The rise was also reflected, says Moroney, by the GDP numbers just released Friday. The U.S. gross domestic product showed an annualized decline of one percent for the second quarter, better than the consensus estimate of a 1.5 percent decline. Still, June-quarter GDP was down 3.9 percent from the same period a year-earlier, the steepest such decline since World War II.

While it is certainly possible that the market's March lows represented a bear-market bottom, Moroney doesn't think the averages have proved this to be the case. So he is remaining defensive and says his equity portfolios are now composed of about 32 percent of Vanguard Short-Term Investment-Grade, a relatively low-risk bond fund.

What's ahead? Many analysts have raised expectations for 2009 earnings, however, Moroney says that to meet consensus estimates for 2010, there will have to be huge profit leaps. S&P 500 and S&P Midcap 400 earnings are projected to be up about 26 percent in 2010, while S&P SmallCap 600 earnings are forecast to surge 47 percent. Meeting such projections will require a rebound in the global economy, as earnings continue to trend lower. Only 30 percent of S&P 500 companies have posted year-to-year profit gains for the second quarter, while roughly 29 percent have delivered sales gains.

Moroney says that now, with earnings-reporting season winding down, economic indicators will increasingly dictate market action. And he warns that at some point over the next several months, doubts regarding the global economic recovery are likely to trigger a significant correction. The ability of the Dow Industrials and Dow Transports to hold above the March lows on such a correction -- and then rebound above the highs established in the rally since March -- will be crucial.

Richard Moroney is the editor of Dow Theory Forecasts.

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