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Tuesday, July 25, 2006

Response to a Manic Monday

The week started with a bang as M&A activity, positive earnings reports and a muffled Middle East sparked a broad-based rally on Wall Street. The Dow Jones Industrial Average surged 182.67, or 1.68%. The S&P 500 index gained 20.62, or 1.66% and the NASDAQ added 41.45, or 2.05%. Lower gold prices and gains for the dollar contributed to the bullish stock movement. Outside the U.S., Japan's Nikkei stock average slid 0.18% but Britain's FTSE 100 rebounded by 2%, Germany's DAX gained 2.33% and France's CAC-40 traded higher by 2%.

Better than expected earnings by Merck & Co. Inc. (MRK, “AAS Recommended Buy“) and Schering-Plough Corp. (SGP, “AAS Recommended Neutral“) combined with significant M&A activity in the form of a leveraged multibillion-dollar buyout of HCA, Inc. (HCA, “AAS Recommended Buy“) and the Advanced Micro Devices Inc. (AMD, “AAS Recommended Sell“) acquisition of ATI Technologies Inc. (ATYT, No AAS Recommendation) generated considerable optimism in the market. Strong M&A activity signals potentially strong economic growth. Bellsouth Corp. (BLS, “AAS Recommended Buy“); SanDisk Corp. (SNDK, “AAS Recommended Sell“); Kraft Foods (KFT, No AAS Recommendation); Texas Instruments (TXN, “AAS Recommended Sell“) and American Express Company (AXP, “AAS Recommended Sell“) all reported increased Q2 profits.

Today is likely the most significant day of the Q2 earnings season with five major Dow components reporting and several other big names. Altria Group Inc. (MO, “AAS Recommended Buy“), DuPont (DD, “AAS Recommended Sell“) and AT&T Inc. (T, “AAS Recommended Buy“) beat Wall Street’s estimates. McDonald’s Corp. (MCD, “AAS Recommended Neutral“) matched estimates while 3M Co. (MMM, “AAS Recommended Sell“) missed and offered cautious guidance.

The indicators that I follow continue to recommend an asset allocation of between 0% and 25% equities. The total universe of stocks, ETF and funds which Alpha Advisor Service, LLC reviews on a daily basis is 1,745. Of those reviewed, 249 are rated "Buy," 912 are rated "Sell" and 584 "Neutral." Market volatility, as expressed by the VIX and VXN, indicates ambiguity for both Bulls and Bears, neither camp entirely sure what the future holds. In addition to more earnings, economic data on consumer confidence and second-quarter gross domestic product growth could propel stocks in either direction. Seven of the eight technical indicators that I use in formulating my market view reversed direction over night, with the 9-Day Moving Average of the MACD the only one continuing a negative bias, which is to be expected.

Despite yesterday’s rally and the subsequent reversal in the indicators, I’m not yet ready to abandon my bearish allocation in favor of a head-long bullish strategy. The markets are changing direction almost daily, and I don’t believe that any sustained rally can develop prior to the Fed’s meeting on August 9th. Instead, I see the next two weeks as an opportunity for market leadership to develop in preparation of a breakthrough to the upside for the remainder of the year.

Those sectors which we perceive as potential leaders continue to include Real Estate, Utilities and Healthcare. Add to that list Telecommunication, which was upgraded this morning in large part due to positive earnings moving index components up. Several sectors, including Energy and Financials, continue to strengthen, yet fall short of being “AAS Recommended Buys.” Those sectors which we are avoiding currently include Transports, Basic Materials, Networking and Semiconductors.

Several equities within those sectors were upgraded to “AAS Recommended Buy’s” this morning. Investors should pay special attention to Essex Property Trust Inc. (ESS); Bear Sterns Companies Inc. (BSC); Allergan Inc. (AGN); Verizon Communications Inc. (VZ) and Bellsouth Corp. (BLS).

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