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Market Outlook: Healthy Skepticism Amid Record Stock Levels

Phyllis Burke Goffney
Tuesday, 17 Jul 2007 | 10:36 AM ET

Many analysts are facing this week's flood of earnings with a healthy dose of skepticism, knowing that results will once again have to exceed Wall Street's expectations to continue the market's advance.

The earnings parade comes as the Dow Jones Industrial Average and the S&P 500 trade at record highs with the blue-chip index touching 14,000 for the first time. But rally aside, analysts believe there are still issues hanging over the market, which have caused a large share of the volatility since June.

"What's really intriguing to us is that you have this laundry list of fears - higher interest rates, weak housing, slowing economy - yet the market is making new highs," Todd Salamone, director of research at Schaeffer's Investment Research, told CNBC.com. "A lot of those fears are being factored into the market via heavy shorting activity."

"I think there is an overhang from the subprime sector and that willl take some time to play out," said Peter Andersen, portfolio manager at Dreman Value Management. "That's a kink in the chain and until that is played out, there will be some volatility."

Banks & Bernanke

Second-quarter earnings are in full swing with reports from major technology companies including Intel, Google, eBay, Yahoo and IBM, but given the subprime mess, it is aslew of reports from regional banks that appears to be causing the most worry.

"If you are a financial institution, you've got some issues," said Richard Suttmeier, chief market strategist at Rightside.com. "I can't see them saying all is better than the quarter before with the real estate and mortgage issues we're facing. No one's talking about the money banks have lent to home builders to build more homes. If you can't sell what's already been built, the inventory will build until something cracks."

A number of large financial institutions including Bank of America, Citigroup, Wells Fargo, JPMorgan Chase and Washington Mutual also report this week..

"The question is how much have they been affected by fallout from the subprime lending crisis," said Martin Weiss, president of Weiss Research. "Next week's earnings will give us an indication of whether the mortgage crisis is limited to a small number of lenders, or if it's affecting banks in general."

Along with earnings, Wall Street this week is getting its share inflation data with both the Producer Price Index and the Consumer Price Index. In addition, inflation will certainly come up when Federal Reserve Board Chairman Ben Bernanke testifies before Congress on Wednesday and Thursday.

"Bernanke's testimony will be one of the big drivers next week," said Frederic Dickson, chief market strategist at D.A. Davidson. "Investors will be expecting him to say some good news about the economy and give his take on inflation."

"I think Bernanke will have to make a statement or answer questions about the mortgage crisis," said Weiss. "The reality is that the housing and mortgage crisis is going to have an impact on how consumers spend money."

Salamone says options expiration next week could also potentially be a market driver. "Thirteen of the last 18 expiration weeks have been positive and we believe that's due to the unwinding of a lot of index put options," said Salamone.

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Getting Defensive

Defensive Options

Many analysts believe the best way to play the current market is to seek out investments that are less likely to be dragged down by any fallout from the subprime situation.

"We like the more defensive categories and that would include healthcare," said Kevin Caron, market analyst at Ryan Beck. "I would throw technology in there as well, even though they are not traditionally considered defensive, but they have clean balance sheets and they are far away from the other problems in the economy."

Caron likes biotechnology giant Amgen and computer maker Dell. "We like to look at companies like these that trade at a low-multiple cash flow," he said. (Ryan Beck owns both stocks for clients.)

The Mining Speculator's Greg McCoach recommends investors keep a small portion of their portfolio in precious metals. "This is a very complicated market so people need to stay diversified," said McCoach. "I think you should have a small holding of actual physical gold and silver. That's real money. Last year, gold returned 24%, better than stocks, and it will probably continue to outperform over the next five years."

Although June retail sales were weaker than expected, Andrew Wolf, food and drug retail analyst at BB&T Capital, says there are good defensive plays in retail. "The defensive sectors really haven't slowed that much," he said. "Drug stores have been growing at about 7%."

Wolf's top recommendation is Walgreen's, the nation's leading drug store in sales. "Walgreen's is trading at about as low as it ever gets," said Wolf. "I look at Walgreen's, frankly, as the last of the large-cap growth stocks that still has plenty of legs in it. This is a company that has 16% long-term earnings growth and is trading really almost at that P/E multiple." (Wolf does not own the stock.)

Other analysts say it may be time for the tech sector to shine and assume market leadership if the rally is to avoid wilting in the summer heat. Whether its defensive or tech stocks or a relief rally for financials, this Teflon market should not be taken for granted.

"Volatility is the buy word that we are going to all have to get used to," McCoach told CNBC.com. "One day it looks great and the next day its doom and gloom. I think the market near-term will grind higher."

Stocks Mentioned in This Story

Phyllis Burke Goffney is a news editor at CNBC.com. She can be reached at phyllis.goffney@nbcuni.com.

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