Timing Outlook Special Edition: Getting Shaky?

1. Summary

The markets have sold off on 6 of the last 7 trading days, including the last 4 in a row, so this is a special edition of the Timing Outlook to assess the damage.

While the Timing Outlook is still (by definition) in positive territory, its value is now 6.0, down from 9.0 less than two weeks ago. While this is the 15th consecutive positive reading, it is hard to ignore the sharp declines in both the market and the Timing Outlook. In 7 trading days, the market has lost 5% of its value. In less than 2 weeks, the Timing Outlook has dropped by a third.

We are heavily into earnings season, and while positive earnings surprises have been prevalent, revenue and outlook surprises have been less so. Further, economic data has been sounding less positive. For example, the most recent survey of consumer confidence fell for the second month in a row. Under my “net news flow” theory, I think that market participants are voting with their dollars and saying the news hasn’t been good enough the last week or two. As stated last time, an extended string of bad news on earnings and/or revenues and/or corporate outlooks and/or economic fronts—such as employment—would probably kill the rally.

I am not ready to declare the rally dead yet, but it bears watching. Just as 3-ish weeks of generally rising prices in March heralded the beginning of this extended and sharp rally, 3-ish weeks of generally falling prices might signal that it has come to a close. We’ve had a couple other similar market drops along the way during this rally, such as in early July (when the S&P 500 fell back 7%), and the market recovered from them and resumed its upward action. It remains to be seen whether this recent negative action is just a short-term interruption or will prove to be longer-lasting.

As always, sell-stops or some other form of downside protection is recommended on your long stock positions (excluding, perhaps, those stocks you hold as dividend-producing investments).

2. Market Performance Since Last Outlook
(“now” figures are as of close Wednesday 10/28/09)

Last Outlook (10/19/09): 9.0 (positive)

S&P 500 last time (10/19/09): 1088
S&P 500 now: 1043 Change: -4%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1043 Change YTD: +16%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1043 Change since 3/9/09: +54%

3. Indicators in Detail

--Conference Board Index of Leading Economic Indicators: New report last Thursday went up for the sixth consecutive month. Positive. +10

--Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

--S&P 500 Market Valuation: The S&P 500’s P/E dropped slightly since last time from 19.5 to 19.3, remaining in neutral territory. As a reminder, I use Morningstar as the source for the P/E ratio based on trailing operating earnings, and I use three "bands" by adding and subtracting 10% from the recent-years’ average (19.3) to allow room for normal market volatility and noise. Thus, P/E < 4 =" Positive" 1 =" Neutral"> 21.2 = Negative = 0 points. At 19.3, therefore, this indicator is neutral. +5

--Morningstar’s Market Valuation Graph dropped slightly from 1.03 to 0.99. The graph continues to meander around 1.0 (which would mean the market is “fairly valued” under Morningstar’s system). The value this time stays within the neutral range of 0.90 to 1.10. (Historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low. All-time high = 1.14 at the end of 2004.) Neutral. +5

--S&P 500 Short Term Technical Trend: The recent sell-off has pulled the index below both its 20-day and 50-day simple moving averages (SMA), dropping this short-term indicator to ambiguous from positive: 20-day SMA > 50-day SMA > Index. +5

--S&P 500 Medium Term Technical Trend: This indicator, which uses the two longer SMAs (50-day and 200-day) is also rendered ambiguous by the index falling below the 50-day SMA. We have: 50-day SMA > Index > 200-day SMA. +5

--DJIA Short Term Technical Trend: The DJIA shows a little different pattern, as the index is still above the 50-day SMA, although it has dropped below the 20-day SMA. Nevertheless, that makes this chart ambiguous. +5

--DJIA Medium Term Technical Trend: This indicator stays positive, as the index has not fallen below its 50-day SMA. +10

--NASDAQ Short Term Technical Trend: The NASDAQ displays a similar pattern to the S&P 500 chart: The index has fallen below both its 20-day and 50-day SMAs. +5

--NASDAQ Medium Term Technical Trend: Same as S&P 500, ambiguous. +5

TOTAL POINTS: 60 NEW READING: 60 / 10 = 6.0 = POSITIVE

Topped Out? Number 2 In a Series

This is the second "Topped Out?" article. The idea is to explore whether the market rally has ended. The questions now are, Has the market run-up ended for awhile? Is it time to take profits off the table, to go to cash, or to go short? Should we go into the woods where the bears hang out?

This has been a great rally: The S&P 500 is up 60% since March 9. But it has gone backward in two of the past four weeks, including -1% last week. Hence this second article in the series.

As I have stated many times, this has been a sentiment-driven bull market. While it has been more powerful than most, in many ways it is a garden-variety recession bull. Of the previous nine recessions before the current one, the stock market bottomed out and started back up several months in advance of the end of the recession. That's what happened here, starting in March. Why? Because investors were looking forward with hope to the end of the recession and the return of an expanding economy.

I use the term "net news flow" to explain what stock buyers have been reacting to during this bull market. They have been reacting to signs--indications--that the economy might be pulling out of the recession. Last March, most any piece of economic data that was "less bad" could be interpreted positively, that the downward economic cycle was losing steam and bottoming out--a necessary precondition to the economy turning back upward.

By now, most indicators have slowed their descent significantly, and some have turned upwards. For example, on Thursday the Conference Board reported that its Index of Leading Economic Indicators rose for the sixth straight month. I track several important indicators in my bi-weekly Timing Outlook reports. Those reports have been positive since March, suggesting that the short-term direction of the market would be up.

In the Q2 earnings season in July-August, about 75% of companies reported earnings that were "positive surprises." That means that they exceeded the consensus expectations of "The Street" (that is, the consensus expectations of stock analysts). All of the positive surprises contributed greatly to a positive net news flow that helped the rally along. In most cases, the Q2 reports did not reflect growing revenue or earnings compared to a year ago, or even to the previous quarter. They simply reflected better-than-expected earnings, a low hurdle to clear. Most of the companies cleared it via fast cost-cutting, including layoffs and hiring freezes.

My thought on the market's reaction to the Q2 earnings reports was that investors were giving companies a "free pass" on revenue improvements. You cannot improve earnings forever by cutting costs. My expectation was that investors would not be so lenient the next time around: They would be looking not only for positive earnings surprises, but also for positive revenue surprises and optimistic forward-looking statements.

Lots of people are skeptical about the sustainablitily of the rally. They are uneasy about its sharpness (one of the strongest short rallies in history), unconvinced that it is supported by real economic improvements, dismayed by the seemingly intractable unemployment problem, and disgusted with government involvement via TARP and other bailout programs. They think a correction (a short-term 10% drop) is inevitable, if not an all-out crash if we get a "double-dip" recession.

The Q3 earnings reports started flowing about two weeks ago. So back to the question: How is the net news flow? According to Bloomberg, Q3 earnings are running very positively. By their count, through last Friday, 85% of companies have beaten consensus expectations. Perhaps more importantly, revenues being reported are better than expected, as 65% of companies have beaten consensus expectations for revenues. And a fair number of companies have included positive forward-looking statements on both earnings and revenue.

How to interpret all this? I would say the news flow is slightly positive, maybe a 6 on a scale of 10. Not blowing the doors off, but perhaps good enough to sustain this rally for a while longer.

Frequent readers know that I already have my exit strategy in place for my Capital Appreciation Portfolio. It has three holdings: SPY (the ETF that tracks the S&P 500); QQQQ (the ETF that tracks the NASDAQ); and IBM. The two ETFs are protected by 8% trailing sell-stops that I update each weekend. I have a 10% trailing sell-stop under IBM.

I am comfortable with my sell-stops. If the market turns downward for a prolonged period of time, they will get me out with most of my profits intact. I suggest that readers protect their long positions in a similar fashion. At any rate, it is too soon to declare that the market has topped out. If the market struggles for a couple more weeks, or my stops get triggered, I'll be back with another report.

Poker Strategy vs. Investment Strategy

I enjoy playing poker, and there are many parallels between poker and investing. I play online on PokerStars.com. They have a tab called "Poker Strategy" for new players. I clicked on it, and I was struck by how much of their simple strategies and tactics apply equally to stock investing.

So I decided to translate their "Poker Strategy" into investment insights. While I have freely substituted investment terminology and added a few thoughts of my own, the basic structure of the following and most of its main points come directly from the PokerStars discussion.

Decisions for the New Stock Investor

To invest at a consistently winning level requires both time and effort. In other words, it takes work. To the extent you can, deciding which type of stock investor you want to be before you start will make your decisions easier. By "type of investor," I refer to such choices as investing for growth, investing for dividends, using fundamentals, using technical analysis, and the like. There is nothing wrong with combining disciplines into a hybrid approach, or using different portfolios to pursue different strategies. But getting your basic strategies down--I recommend writing them out--is important.

Make Good Decisions – the Results Will Follow

Even the best investors in the world have losing periods. Don't make the mistake of expecting to win every time you invest. Your goal should be to make decisions to the best of of your ability at all times. If you do, the total return on your investing will take care of itself, and it will improve as you improve the quality of your decions. Many investors make the mistake of judging their ability based on the results of each decision. Your goal should be to make the best possible play every time. The closer you come to this, the better your results will be.

By "decisions," I refer to decisions to buy, hold, sell, or stay away entirely. Selling or staying away are investing's equivalents to folding a hand.

The Mathematics of Poker

Investing is a mathematical game, and it’s a game of incomplete information. That may sound complicated, but it really isn't. On a very basic level, winning investing starts with the selection of which stocks or ETFs to buy or (more importantly) to avoid. This is called "stock selection." If you embark with the best decisions as well as you can determine them, you will increase your odds of overall investing success. In this context, stock selection includes not only identifying excellent companies or ETFs, but also determining favorable prices at which to buy them ("valuation").

Beyond Starting Hands

Stock selection is fundamentally important, but it’s only one piece of the puzzle. Once you have mastered solid guidelines for purchase decisions, the next area you should work on is your play for the rest of the time. I call this "portfolio management." The area that separates better investors from the rest is that the better investors tend to play much better during the remainder of the process, after the starting stock or ETF selections are made. This is especially true concerning the decisions made about when to end the holding period for every stock or ETF purchased. These skills involve risk management, stop-loss techniques, deciding when a trend has played out, recognizing red flags, knowing what to do when a company cuts its dividend, and the like. Even small improvements in an investor's portfolio management can have a tremendous effect on that investor's lifetime success.

Avoiding Tilt

Another meta-skill that should be part of a winning investor's strategy is avoiding tilt. ("Tilt" is a poker term for someone who has gotten emotional--perhaps because of a bad result--and starts making bad decisions, perhaps in an effort to make it all back at once.) Your emotions can work against you, but only if you let them. Emotional play results in poor decisions and lost money. Tilting and steaming can happen to anyone, and sometimes the only cure is a break from the game. That’s okay; the game will still be there tomorrow.

Rally In Eighth Month; Timing Outlook Remains Positive

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1. Summary

The stock market's rally passed its 7-month anniversary on October 10. It is up 61% since then, making this one of the sharpest rallies on record in terms of speed + magnitude.

The Timing Outlook bounced back up to 9.0, remaining positive. That makes 14 consecutive positive readings, roughly matching the time of the rally. Reminder: The interpretation of the Timing Outlook has been changed to eliminate “neutral.” Any reading of 5.0 or above is “positive,” and any reading below 5.0 is “negative.” (If you missed that change, scroll down to the article below this one.)

Q3 earnings season started a couple of weeks ago, and most companies reporting so far have beaten analysts' earnings estimates. Lots of people, including me, are also watching revenue results and the companies' forward-looking statements about their expectations for Q4 and 2010. Those areas have been mixed so far.

An extended string of bad news during earnings season (earnings missing estimates or poor outlooks), or on other fronts such as employment, would probably kill the rally. That said, such a string of bad news has not materialized since the rally began in March. That in itself seems remarkable and has many pundits questioning how long the rally can go on.

As always, use sell-stops or some other form of downside protection to protect profits already accrued but not realized, and also to protect against losses if the market suddenly reverses course. (This suggestion does not necessarily apply to stock positions held as long-term dividend-producing investments).

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday 10/16/09)

Last Outlook (10/5/09): 7.5 (positive)
S&P 500 last time (10/5/09): 1025
S&P 500 now: 1088 Change: +6%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1088 Change YTD: +20%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1088 Change since 3/9/09: +61%

3. Indicators in Detail

--Conference Board Index of Leading Economic Indicators: No new report since last time. That report showed its fifth consecutive monthly increase. Positive. +10

--Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

--S&P 500 Market Valuation: The S&P 500’s P/E rose since last time from 18.2 to 19.5, or back into neutral territory. As a reminder, I use Morningstar as the source for the P/E ratio based on trailing operating earnings, and I use three "bands" by adding and subtracting 10% from the recent-years’ average (19.3) to allow room for normal market volatility and noise. Therefore, P/E < 4 =" Positive" 1 =" Neutral"> 21.2 = Negative = 0 points. At 19.5, therefore, this indicator is neutral. +5

--Morningstar’s Market Valuation Graph increases from 0.98 to 1.03. The graph has been yo-yo-ing back and forth around 1.0 (which would mean just right, like the littlest bear’s porridge) since late July. That is noteworthy, as the stock market has risen 16% since then while this indicator has remained near 1.0. That means, of course, that even as stock prices have risen, Morningstar's analysts have been increasing their fair value estimates of stocks' worth at about the same pace, which is a positive sign. The currrent reading of 1.03 is within the neutral range of 0.90 to 1.10. (Historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low. All-time high = 1.14 at the end of 2004.) Neutral. +5

--S&P 500 Short Term Technical Trend: The market has risen sharply since the last Timing Outlook (up 6%). The effect on the charts has been to bring them back into their most positive configuration: Index > 20-day SMA > 50-day SMA > 200-day SMA. Positive. +10

--S&P 500 Medium Term Technical Trend: Positive. +10

--DJIA Short Term Technical Trend: Positive. +10

--DJIA Medium Term Technical Trend: Positive. +10

--NASDAQ Short Term Technical Trend: Positive. +10

--NASDAQ Medium Term Technical Trend: Positive. +10

TOTAL POINTS: 90 NEW READING: 90 / 10 = 9.0 = POSITIVE

Changing the Interpretation of the Timing Outlook

I am making a small change to the interpretation of the Timing Outlook.

First, a little history. The Timing Outlook (TO) was invented during the writing of Sensible Stock Investing. Originally, the TO had eight indicators. Four of them came from another investment Web site and were used by permission. Those four were all trend indicators. From the beginning, the TO was calculated by assigning each indicator a score of 0, 5, or 10, and then calculating a simple average to get a single number between 0 and 10.

In mid-2008, the other site discontinued its indicators. So I home-brewed six trend indicators of my own, replaced the four missing ones for a total of ten indicators, and created the Timing Outlook that is in use today.

I began publishing the TO in this Newsletter in 2007. At a reader's suggestion, I began writing more detailed articles--showing the individual indicators and adding commentary--in 2008. These days, I publish a new TO article each time I recalculate it, generally every other week.

From the beginning, the TO was not meant to be a single, exclusive timing device. Rather, it was part of the Sensible Stock Investor's toolkit. The idea was to increase the likelihood of successful investment decisions. I wanted something to improve the probability that decisions to buy, hold, or sell would get off to a good start.

As described in the book, the interpretation of the Timing Outlook was in three "zones":
--0-4 was considered negative;
--4-7 was considered neutral; and
--7-10 was considered positive.

Recently I went back to evaluate how helpful or accurate the Timing Outlook has been since I began calculating it regularly in 2006. In a nutshell, it does seem to provide an edge, although of course it is not correct all of the time. But it has been correct in predicting the direction of the market two weeks out 58% of the time; 59% for the market's level one month later; and 68% for three months later. One thing I discovered in doing this review is that using a 3-period simple moving average (SMA) of the Timing Outlook improves those percentages slightly. Another point of interest is that, not surprisingly, it does better in markets that are trending as distinguished from up-and-down markets.

That information provides the background for the change I am making.

After examining the data, I have decided that three zones are too granular. So the new simplified interpretation will be just whether or not the Timing Outlook is 5 or more:
--0-4.9 will be considered negative; and
--5-10 will be considered positive.

In this context, "positive" means that the Timing Outlook is suggesting that the market is more likely to move higher in the short term, and "negative" suggests that the market is more likely to move lower. The ambiguous "neutral" category has been eliminated.

Starting on "TOP 40 DIVIDEND STOCKS FOR 2010"

In the past two weeks, I have begun work on THE TOP 40 DIVIDEND STOCKS FOR 2010, my annual e-book for investors working on a dividend strategy. My hope this year is to release it in January, or three months sooner than 2009's March release and five months ahead of 2008's May release.

It seems like the earlier in the year it comes out, the more helpful it will be. The trade-off is that I will do most of the research without full-year data for 2009, but overall I think it's a good compromise to get it out sooner.

I haven't decided on the sub-title for the new edition. I want to strike the perfect balance between boring and hyperbolic. Many people think that dividend stocks are boring--unaware, I guess, that over long periods, dividend stocks have delivered the best total returns of any category of stocks by several percent. On the other hand, I don't want to insult people's intelligence with ridiculous claims like "How to Turn $5,000 into a Million with Dividend Stocks."

Here were the subtitles I used in the first two editions:
2008: How (And Why) to Build a Cash Machine of Dividend Stocks
2009: Dividend Investing for the Long Haul

If you have an idea for a great sub-title, drop me a line. If I use your suggestion, I'll send you a free copy of the e-book when it comes out.

That's not my main reason for writing this post. I want to tell you about something I've noticed as I apply an initial series of qualifying tests to the nearly 700 candidates for the Top 40. Three of the first-level tests are:
--Stock must have shown positive total returns in 3 of the last 5 years.
--Stock must have delivered total returns greater than 0% over the past 5 years.
--Stock must have raised its dividend in each of the past 5 years.

I'm about halfway through the list now. What I've noticed is the strong correlation among these three tests in many stocks that are failing the first round of hurdles. Usually, a stock that fails one of them fails all three. I guess it's no surprise that the first two are correlated. After all, a stock that has delivered negative returns in 3 out of 5 years would have difficulty delivering a total return above zero without an extraordinary year out in the other two.

But the interesting part is the correlation with the last hurdle: Must have raised its dividend for the past 5 years. That means there is a connection between the stock's total return (which includes price increases) and its dividend. If a stock did not raise its dividend in each of the past 5 years, that means it either cut it or froze it.

I'm not sure which comes first, I see this as a chicken-and-egg situation. That is, does a stock's price fall because it freezes or cuts its dividend, or does a cut or frozen dividend merely reflect lousy financial performance across the company. I have read studies that suggest it is the first, and I have written articles suggesting that a dividend cut or freeze can be an early warning sign of other bad news about to emanate from a company.

Whether there is a cause and effect, though, the lesson for the dividend investor is clear: A dividend cut or freeze is a big fat warning signal about the viability of the stock itself as an investment. That's why you won't see any stocks with recent cuts or freezes among next year's Top 40.

Timing Outlook Still Positive Despite Market Drop

1. Summary

The Timing Outlook drops from 9.0 to 7.5, still “positive” but less strongly so. That makes 12 of the last 13 readings positive, roughly matching the time of the rally. The “September swoon” never happened: the market rose 3% in September.

But October got off to a crummy start, capped by the bad employment news last week. Earnings season kicks off this week, which always brings a ton of news for investors to react to. Personally, I’ll be watching not only for earnings “surprises,” but also for revenue growth (which has been weak throughout the rally), companies’ forward-looking statements, and updated employment statistics.

The market is not technically overvalued, but it won't matter if companies' outlooks are not positive and/or the employment picture stays dismal. Either would would probably kill the rally. I suppose it is possible that a high percentage of positive revenue and earnings surprises for the past quarter could by themselves extend the rally, but I doubt it.

As always, sell-stops or some other form of hedging are recommended on your long stock positions.

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday 10/2/09)

New Outlook (10/5/09): 7.5 (positive)

Last Outlook (9/21/09): 9.0 (positive)

S&P 500 last time (9/21/09): 1068
S&P 500 now: 1025 Change: -4%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1025 Change YTD: +14%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1025 Change since 3/9/09: +51%

3. Indicators in Detail

--Conference Board Index of Leading Economic Indicators: No new report since last time. That report showed its fifth consecutive monthly increase. Positive. +10

--Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

--S&P 500 Market Valuation: According to Morningstar, the S&P 500’s P/E fell back from 18.9 last time to 18.2. This is within the neutral range of 17.4 to 19.3, and the drop halted (at least temporarily) what had become a steady march toward “overvalued” territory. Neutral. +5

--Morningstar’s Market Valuation Graph drops to 0.98 from 1.04. This is within the neutral range of 0.90 to 1.10, and as above, the decline interrupted a march toward “overvalued.” (Historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low. All-time high = 1.14 at the end of 2004.) Neutral. +5

--S&P 500 Short Term Technical Trend: With the drop the last couple of weeks in the stock markets, all three charts have lost their ultra-positive quality. The actual index value in each case has dropped below its 20-day simple moving average (SMA) but is still above its 50-day SMA. So on each chart, the lineup is this: 20-day SMA > Index > 50-day SMA > 200-day SMA. For this short-term indicator, the chart drops from positive to ambiguous, as the index value is between the 20-day and 50-day SMAs rather than above them. +5

--S&P 500 Medium Term Technical Trend: This remains positive, as the index remains above the 50-day SMA, which remains above the 200-day SMA. +10

--DJIA Short Term Technical Trend: Same as S&P’s short-term trend: Ambiguous. +5

--DJIA Medium Term Technical Trend: Same as S&P’s medium-term trend: Positive. +10

--NASDAQ Short Term Technical Trend: Same as the other two: Ambiguous. +5

--NASDAQ Medium Term Technical Trend: Same as the other two. Positive. +10

TOTAL POINTS: 75 NEW READING: 75 / 10 = 7.5 = POSITIVE

A Bad News Week

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I have been saying for some time that the continuation of the rally will be strongly influenced by the "net news flow." That is a subjective concept, as obviously reasonable minds can differ over whether a day's or a week's flow of news was on balance positive, negative, or so-so.

Not this week. The news was almost unrelentingly negative:

• Robert Shiller, of the widely followed Case-Shiller home price index fame, stated that he believes home prices will move sideways for five years.
• Mortgage loan delinquencies increased to 5.4% in Q2.
• Initial unemployment claims increased to 551,000 in the latest reporting week.
• The ISM Manufacturing Survey fell after several months of increases. Its employment component worsened slightly to 46.2 (a reading under 50 signals contraction).
• Consumer confidence fell in September.
• Today's Labor Department report was dismal. The nation's job losses accelerated in September, driving the unemployment rate to a 26-year high of 9.8%. Nonfarm payrolls fell by a greater-than-expected 263,000 in September, the 21st consecutive month of job losses. Since the recession began in December 2007, 7.2 million jobs have been lost and the unemployment rate has doubled. The number of unemployed people rose by 214,000 to 15.1 million. And of those, 5.4 million have been out of work longer than six months, accounting for a record 36% of the jobless. More than a half a million people dropped out of the labor force, and the employment participation rate fell to 65%, the lowest in 23 years. The average duration of unemployment rose above 26 weeks, a record high. An alternative gauge of unemployment, which includes discouraged workers and those with part-time employment, rose to 17% -- the highest in the 15-year history of the data. Total hours worked in the economy fell by 0.5%. The average workweek dropped back to an all-time low of 33 hours.

There is no way to depict this week's net news flow as anything other than disastrous. I don't "rate" every week's news flow, but I don't think there's been a week this bad since the rally started in March.

The S&P 500 fell this week from 1044 to 1025, or about 2%. And that illustrates the relationship between news flow and the market: The market is sentiment-driven, and sentiment is driven by news and the interpretation of the news. Bad news week = bad market week.

No time for panic yet (actually, there's never any need to panic, just follow cool portfolio management practices). The market is down just 4% from its most recent high, and it is still up 52% from its March low. Next week begins the earnings season for Q3, during which official earnings reports and their accompanying verbiage will provide much of the news flow.

In the last earnings season, about 75% of companies reported earnings that "surprised to the upside," meaning they exceeded analyst's expectations. That created a fairly steady positive news flow for weeks that helped the rally along tremendously. This time, it may be more difficult for companies to impress the market, given that most of last quarter’s positive surprises were due to severe cost-cutting, not revenue growth. Eyes will be on revenue growth as well as profits this time around.

To me, the two most important potential threats to the rally are consumer spending and unemployment. Both speak directly to revenue growth as somewhere between 65% and 70% of the U.S. economy consists of consumer spending. Most data suggest that the "average consumer" has become more conservative in day-to-day spending. This is demonstrated by lagging store sales, deleveraging of personal credit, and higher savings rates. There's no telling how long these trends will last, but common sense suggests they are closely tied to the job market--whether people have jobs and how secure they feel their job is. We're somewhere around the tipping point now: The recession is probably close to being technically over, but that is not yet reflected in the job market. If this becomes a "jobless recovery," or if there is a "double dip" recession as some are predicting, the stock market rally will probably fizzle out.