Why the Dow May Crash This Week

If you're reading this, you probably know the market exploded at the end of last week. Following positive news out of Europe and the Federal Reserve's decision to unleash a third round of quantitative easing, the Dow Jones Industrial Average (INDEX: ^DJI  ) gained a staggering 300 points between Monday and Friday. The index increased by 200 points on Thursday alone, marking the best day of the year for the Dow.

But that was last week, and the question on traders' minds now is: What's in store for the week ahead?

Why the Dow could crash
It goes without saying that monster gains like last week's can't be replicated continuously. This is particularly true when the impetus was exogenous, like news about another round of quantitative easing. To illustrate this point, a recent Reuters article compared the Fed's decision with that of a rehab clinic "offering addicted investors a synthetic high." The article continued: "The punch line is that you always need more and more to get the same high and each bout of euphoria is followed by a crashing comedown."

Although I'd like to be more optimistic about the coming week, I see two reasons not to be.

In the first case, the market's reaction last week was clearly irrational. The performance of financial stocks, and banks in particular, serves as strong evidence. Quantitative easing is almost categorically bad for banks. Its purpose is to bring down the long-term interest rates that depository institutions rely on for a significant proportion of revenue. As these rates have come down since the beginning of last year, for example, Bank of America (NYSE: BAC  ) has lost roughly $2.5 billion in net interest income a quarter! Yet B of A was nevertheless the best-performing Dow stock last week.

In the second case, to borrow a phrase from my colleague Alex Dumortier, there's a growing chorus of evidence that an earnings recession has already begun. Alex points to a number of ominous variables to back up this assertion: Margins are at cyclical highs, stock repurchases are down, and at the end of August, "data provider Factset reported that the proportion of companies that have given negative guidance for the third quarter was on track to be the highest since the firm began tracking this figure in Q1 2006."

The list of companies guiding downward reads like a "Who's Who" roster of Corporate America. The trend began in July, when economic bellwether United Parcel Service (NYSE: UPS  ) noted:

As we look toward the second half of the year, customers are more concerned as greater uncertainty exists. Additionally, economic growth expectations have come down. Consequently, we are reducing our guidance for 2012 diluted earnings per share to a range of $4.50 to $4.70, an increase of 3% to 8% over 2011 adjusted results.

A slew of others have since followed suit. Earlier this month, both FedEx (NYSE: FDX  ) and Intel (Nasdaq: INTC  ) warned investors to reduce expectations going forward. And even the insanely popular burrito chain Chipotle Mexican Grill has felt the proverbial heat. After announcing at its last earnings release that it anticipates "[m]id-single digit comparable restaurant sales growth for the full year," investors sent the chain to the pillory, pushing its stock down more than 22% in one day alone.

What's an investor to do?
As I intimated earlier, all of this suggests to me that the market will head lower -- if not this week, then in the not-too-distant future. So what should you do? If you're a long-term investor, as most of us at The Motley Fool are, then the answer is "nothing," as the market, and good companies in particular, will eventually continue to meander upward. At the same time, however, I think investors would be wise to let this storyline play out before getting too aggressive on the purchasing front.

While the market, and bank stocks in particular, may be a bit frothy coming off last week's gains, there's a strong case that Bank of America is nevertheless massively undervalued. In a recent in-depth report, for example, our in-house bank analyst Anand Chokkavelu explains why its stock could "double or triple within the next five years." Find out why for yourself before it's too late.

Fool contributor John Maxfield owns shares of Bank of America. The Motley Fool owns shares of Intel, Chipotle Mexican Grill, and Bank of America. Motley Fool newsletter services have recommended buying shares of FedEx, United Parcel Service, Intel, and Chipotle Mexican Grill. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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