What You Should Do if Markets Stall

“Calling the Trend” Column, by George Leong, B. Comm.

What we are seeing in the stock markets is being driven by optimism towards the economy and earnings. Over 60% of S&P 500 companies have beaten Street EPS estimates. Microsoft Corporation (NASDAQ/MSFT) and Amazon.com, Inc. (NASDAQ/AMZN) blew away estimates. Markets rallied, but not to the degree that you would expect, since much of the easy gains have been made in the recent weeks leading up to the earnings season. My feeling is that markets may stall in the near term.

The reality is that, while the third-quarter results are encouraging, there remains an issue with the earnings quality that has largely been driven by cost cuts and not revenue growth. I feel that this will continue to be an issue.

The International Monetary Fund (IMF) suggested that world economies are doing well, but encouraged the need to drive fiscal spending and maintaining interest rates at a low level. The IMF predicts 3.1% global growth in 2010, largely driven by emerging economies in China and India. Fed chief Ben Bernanke said that China appears to be leading the global recovery. You’ve got to be impressed with the Chinese economy, which grew at a better than expected 8.9% in the third quarter, up from 7.9% and 6.1% in the second and third quarters, respectively. However, with the growth, you should watch for inflationary pressures. Many multinational companies are seeing growth in China to help compensate for slowing in domestic economies in North America and the European Union. Moreover, strength in China spills over to other Asian countries and India. Keep on riding the Chinese picks.

Advertisement

At this point, stock markets are at a crux, looking for direction, facing selling pressure, and needing reasons to trend higher.

In economic news, inflation remains a non-issue, as both the PPI and CPI declined in September. A bit of concern for deflation. The housing market remains weak, with worse than expected readings in Building Permits and Housing Starts.

I sense that traders are pausing given the rally. Much of the strong earnings have been discounted into the market, so we need to see a fresh catalyst drive the market. Weak housing data are pressuring stocks and forcing to us rethink the strength of the economic recovery. The lack of revenue growth is a major factor generating some apprehension.

Gold continues to hold above $1,050 an ounce and oil is above $80.00, as the USD Index continues to be weak and at a decade low. The decline continues to drive up commodities. The weak U.S. dollar will help export markets, but will also hamper the demand for U.S. assets. It’s best to invest in some foreign stocks to gain some foreign exchange exposure. Canadian stocks have been surging, and you also gain from its strong rise against the U.S. dollar, as it approaches parity.

If markets stall, you may consider writing some covered calls on your long positions to generate some premium income. Be careful, as this strategy is vulnerable to rallies in the stock and loss of potential profits should the stock price move above the strike price where you would be forced to sell the stock.

The key in this market is to monitor your positions and take profits on the big winners. The last thing you want is to see the easy gains disappear.