Has the Dow Jones Industrial Average Topped?

Sam Subramanian PhD, MBA

The Dow Jones Industrial Average ($INDU) has lost over 550 points or 5.2% in the last three days. This loss has pushed the popular benchmark to a 2.5% loss for the year. The sharp decline has been enough to inject fear into some investors. The volatility index ($VIX), a measure of investor fear, is up 55% in just the past three days.

With shares of Alcoa (AA), Bank of America (BAC), JPMorgan Chase (JPM), Intel (INTC), International Business Machines (IBM), and Google (GOOG) down between 4% and 23% after releasing fourth quarter results, earnings reports have taken much of the blame for this reversal. In reality, they are just one among many factors.

President Obama's proposals and developments overseas are equally to blame.

The Noose of Financial Regulation

Uncertainty on the impact of President Obama's proposals on the financial sector is a significant factor contributing to the decline. The proposals could impair the profitability of banks. They call for splitting up large banks, imposing TARP-related fees, and prohibiting banks from running proprietary trading operations or investing in hedge funds.

News from China and Australia

With China's economy growing at a breakneck 10.7% rate in the fourth quarter, the nation’s central bank is taking steps to curb loan growth. The resulting sell-off in Chinese stocks rippled through the rest of the world. Meanwhile, reports of a resource rent tax proposal hurting mining company profits rattled stocks in Australia and Asia.

Stock Market Predictions: DJIA Forecast

Unlike previous pullbacks during the bull-run from March 2009, the current sell-off has managed to push the DJIA easily below its 50-day moving average.

After a 11-month bull-run, the Dow Jones Industrial Average (DJIA) has broken below its 50-day moving average.

High expectations are a risk for the stock market. Prior to the start of the fourth quarter earnings reporting season, the S&P 500 ($SPX) traded at 25 times operating profits, the highest level since 2002. Analysts expected S&P 500 companies to record a 67% increase in year-over-year earnings.

The tempo of earnings reports moves into higher gear this week with 12 Dow Jones Industrial Average companies and 130 S&P 500 member companies stepping up to the earnings podium. 3M (MMM), AT&T (T), Boeing (BA), Caterpillar (CAT), Chevron (CVX), DuPont (DD), Johnson & Johnson (JNJ), Microsoft (MSFT), Procter & Gamble (PG), Travelers (TRV), United Technologies (UTX), Verizon (VZ) are the 12 DJIA companies scheduled to report.

If the improvement in profits continues to remain a cost-cutting and restructuring story instead of revenue recovery, it is conceivable that the DJIA will break below 10,100 in the near-term and attempt to seek support around 9,300. Overvalued sectors and companies could be at risk for a substantially larger decline.

Over a longer period, corporate profits should be a major driver of share prices. The December reading of the Conference Board’s index of leading economic indicators recently surprised to the upside auguring well for continued economic expansion. If the economy expands and corporate profits grow, the DJIA can climb back above its early 2010 high of 10,767 later this year.

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