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Investment Strategy

Focus on Earnings

By Elliott H. Gue, on Oct. 12, 2013

The partial government shutdown delayed most economic news releases over the past week, leaving the market guessing as to the state of the economy.

And with only 32 S&P 500 companies having reported third-quarter results, earnings season hasn’t gathered enough momentum to distract investors from speculating whether Congressional Democrats and Republicans would hammer out an agreement to fund the government and raise the debt ceiling.

As we predicted last week in The Government Shutdown and the Stock Market, the partial shutdown doesn’t appear to have hit equities. In fact, the S&P 500 has generated a 1.4 percent gain since the government began furloughing employees. We expect legislators to reach a compromise by midweek, which should limit the shutdown’s effect on fourth-quarter gross domestic product to less than 0.5 percent.

Needless to say, we look forward to the market shifting its focus from Washington, DC, to corporate earnings season.

The Consensus View

Wall Street’s consensus estimate calls for the S&P 500’s constituents to grow their earnings by 1.5 percent year over year–a low hurdle when you consider that the economy has strengthened and analysts called for an earnings increase of 2.7 percent only two months earlier. If you exclude the financial sector, expectations for earnings growth increase to 1.9 percent, down from 3.3 percent two months ago.

In the third quarter, the S&P 500 generated a total return of 5.24 percent. Since Capitalist Times Premium launched on June 20, 2013, we’ve argued that a strengthening US economy would favor industrials and other cyclical sectors in the back half of the year. (See The Great Rotation.)

This call proved prescient: Industrials, consumer discretionary and basic materials–three of the S&P 500 sectors most leveraged to the economy–were the index’s top three performers.

Source: Bloomberg

The outperformance of the industrial and consumer-discretionary sectors reflects the consensus expectation that their earnings growth will accelerate in the fourth quarter and coming year.

Source: Bloomberg

Although third-quarter earnings estimates for the industrial sector have changed little since mid-August, analysts’ consensus fourth-quarter expectations for the group have increased over the past two months. This group is the sole S&P sector for which the Bloomberg consensus estimate of fourth-quarter earnings has ticked higher, reflecting a growing confidence in global economic growth through year-end.

Meanwhile, the industrial sector’s price-to-forward-earnings multiple has increased steadily since we highlighted the group in June. However, with this segment of the S&P 500 still trading below its post-1999 valuation average of 16.5 times forward earnings, we expect the strengthening global economy to drive further upside in the fourth quarter and early 2014.

Wall Street analysts have lowered their estimates for consumer-discretionary stocks since mid-August, but the consensus forecast for this group’s third- and fourth-quarter earnings growth remains among the strongest of the 10 economic sectors.

Looking solely at earnings revisions over the past four weeks, the industrial sector again stands out.

Source: Bloomberg

Sentiment toward the health care sector has also improved, with analysts revising their earnings estimates higher for the fourth quarter of 2013 and the first and second quarters of 2014. Although health care has a reputation as a defensive sector, this market segment includes several subsectors–medical devices and biotechnology leap to mind–that tend to trade on momentum and have the potential to make big moves. We’ll highlight some our top health care picks in the next issue of Capitalist Times Premium.

Drilling Down

Tracking earnings estimates and revision trends can help to identify worthwhile investment opportunities, but these data tell only tell part of the story.

Case in point: Although analysts consistently have lowered their earnings estimates for the basic-materials sectors, this subset of the S&P 500 generated the best total return in the third quarter. We expect these stocks to continue their strong performance, especially as the growth outlook for Europe and China continues to improve.  

We recently added a basic-materials name to the Wealth Builders Portfolio that generates 26 percent of its revenue in the US, with about 54 percent coming from Europe and Asia. Our newest stock pick also wins points for returning capital to shareholders via dividends and share repurchases, while its inexpensive valuation implies an upside potential of at least 40 percent. Subscribe to Capitalist Times Premium today for instant access to this stock pick and the Entire Wealth Builders Portfolio.

The energy sector has also suffered significant earnings downgrades, though investors should remember that major integrated oil companies such as ExxonMobil Corp (NYSE: XOM) dominate this segment of the S&P 500.

Source: Bloomberg

Analysts expect ExxonMobil and other S&P 500 companies that produce oil and gas  to post lower earnings through the first quarter of 2014. The recent contraction in US refining margins and the prominence of integrated oil companies in the S&P 500 likely account for much of these earnings downgrades. For example, Chevron Corp (NYSE: CVX) last week announced that the firm’s third-quarter earnings declined sequentially, attributing these disappointing results to downstream profits that were expected to be “significantly lower.”

In contrast, analysts expect the energy equipment and services stocks in the S&P 500 to post impressive earnings growth over the next four quarters, thanks to robust global drilling activity and healthy commodity prices.

Elliott H. Gue is founder and chief analyst of Capitalist Times and Energy & Income Advisor.

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