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

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 (Nasdaq: 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.

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Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On August 31, 2011, at 4:44 PM, sheldonross wrote:

    "The third quarter is historically volatile "

    Every time I hear things like this I always recall the Mark Twain quote:

    "OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks in. The other are July, January, September, April, November, May, March, June, December, August, and February."

  • Report this Comment On August 31, 2011, at 4:48 PM, LouisFBrooks wrote:

    I have one word for you: Greece. Oh, you thought we were through with that? Think again.

  • Report this Comment On August 31, 2011, at 10:52 PM, ETFsRule wrote:

    "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."

    Well, this begs the question: why were those profit margins so high in Q1 and Q2? And, what is going to cause them to drop?

    I could actually see margins going even higher. Oil is cheap, inflation is very low, and consumer spending continues to increase at a healthy rate (almost 5% right now).

    "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."

    I don't understand why you're talking about volatility in such negative terms... wouldn't you depend on high volatility in order to achieve such high annual returns?

  • Report this Comment On September 01, 2011, at 12:17 AM, Frankydontfailme wrote:

    Absolutely agree Alex. Would like to see MSFT closer to 24, however.

  • Report this Comment On September 01, 2011, at 9:27 AM, Frankydontfailme wrote:

    ETFsRule. What is going to cause them to drop?

    1) Higher dollar

    2) Run out of employees to fire

    3) Tepid (to say the least, consumer demand for all but a few products)

    "I could actually see margins going even higher. Oil is cheap, inflation is very low, and consumer spending continues to increase at a healthy rate (almost 5% right now)"

    Oil is not particularly cheap, especially if you look at Brent (few use WTI).

    Inflation is not particularly low.

    http://bpp.mit.edu/

    Consumer spending increasing? At a healthy rate? Oh you mean savings decreasing and consumers going deeper into debt. Not so sustainable.

    If a reader wanted to contrast a solid article with a classic example of how to think incorrectly about our world's economy, ETFs provided such a counterpoint.

  • Report this Comment On September 01, 2011, at 12:00 PM, ETFsRule wrote:

    "Oil is not particularly cheap, especially if you look at Brent (few use WTI)."

    Brent is currently cheaper than it was 6 months ago, and it's cheaper than it was for the majority of Q2 2011. This should have positive effects for the economy in Q3, as compared to Q2.

    "Inflation is not particularly low."

    It's at a perfectly normal level, between 3-4%. It will be a bit lower once the August numbers are factored in.

    "Consumer spending increasing? At a healthy rate?"

    Yes, 5% is a good number.

    "Oh you mean savings decreasing and consumers going deeper into debt. Not so sustainable."

    The savings rate is decreasing, really? Are you sure about that?

    Consumers going deeper into debt?! What numbers are you looking at??

  • Report this Comment On September 01, 2011, at 3:01 PM, Frankydontfailme wrote:

    3-4% inflation is normal in your world apparently. I'll leave that one alone.

    Yes, oil prices are slightly lower. They are lower because of lower demand ie less production as seen in the PMI data for the last three quarters (less production because less demand).

    However, corporate profits were rising last year mostly because of the weaker dollar. If I'm putting words in your mouth please correct me, were you saying stocks should go up with oil at 115 because oil prices had to go down? Is high oil prices or low oil prices bullish? Which is it? The truth is the oil price is indicative of speculative sentiment towards the economy (currently not so good, although starting to price in more money printing).

    Young people, and especially students, are definitely going deeper into debt. This is our nation's future.

    http://www.uspirg.org/higher-education/student-debt/private-...

    As for Americans on average, yes they are deleveraging. In my opinion, this is partly due to rational people paying off debt. Mostly, however, this is due our government not requiring people to pay their mortgages (oversimplification but true). As a result banks are insolvent and wouldn't lend even if anyone wanted to releverage. This is not bullish...

    Also, remind me, the 5% number was based on one month (July right?) Are you sure this is a long term trend or just a hurricane/lower gas price induced releveraging?

  • Report this Comment On September 01, 2011, at 6:48 PM, ETFsRule wrote:

    "3-4% inflation is normal in your world apparently. I'll leave that one alone."

    Yup, in my world that is right at its historical average. I don't know how you could get any more normal than that.

    "Yes, oil prices are slightly lower. They are lower because of lower demand ie less production as seen in the PMI data for the last three quarters (less production because less demand)."

    That's one explanation. But I'm sure you would say that higher oil is bearish, and lower oil is also bearish.

    "If I'm putting words in your mouth please correct me, were you saying stocks should go up with oil at 115 because oil prices had to go down?"

    Uh, not necessarily, but the oil price is one factor that affects corporate profits. What I said is that cheaper oil is good for the economy. Do you disagree with that?

    "As for Americans on average, yes they are deleveraging. In my opinion, this is partly due to rational people paying off debt."

    Agreed.

    "Mostly, however, this is due our government not requiring people to pay their mortgages (oversimplification but true)."

    Oversimplification and false. Unsupported by facts.

    "As a result banks are insolvent and wouldn't lend even if anyone wanted to releverage. This is not bullish..."

    Insolvent, eh? I suggest taking a look at bank profits, excess reserves, etc.

    "Also, remind me, the 5% number was based on one month (July right?) Are you sure this is a long term trend or just a hurricane/lower gas price induced releveraging?"

    You tell me: has consumer spending been trending higher or lower?

    http://research.stlouisfed.org/fred2/graph/?g=1Wq

  • Report this Comment On September 02, 2011, at 10:29 AM, Frankydontfailme wrote:

    Fair enough, all of your responses are rational so I have nothing left to argue.

    You are wrong though, we are about to double-dip (actually worse, we're still in the same Depression) It's interesting that people can look at the same data and see the opposite.

    I suppose we will have to wait and see.

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