Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: With earnings season for the third quarter set to begin, estimates on Wall Street have hit very pessimistic levels. We discussed last week that this could be the troughing quarter. If so, could this period just be companies shaking off the rest of the cobwebs before returning to positive earnings growth?
Stovall: First off, S&P Capital IQ is projecting a near 2-percent year-over-year decline in operating earnings for the S&P 500 in the third quarter of 2012. Two sectors that are expected to get beaten up pretty badly on an earnings basis are Energy and Materials, each down more than 18.5 percent. We’re also expecting to see a 6.7-percent decline in Utilities earnings, a 4.7-percent decline in Telecom Services earnings, as well as a 4.5-percent decline in Healthcare earnings.
In terms of shaking off the dead wood, that is certainly a possibility because when you look to the fourth quarter of 2012 estimates, as well as looking to the calendar year of 2013, it appears as if the earnings picture is expected to get a little bit brighter. In the fourth quarter, Capital IQ consensus is looking for a 9.7-percent increase with all 10 sectors posting year-over-year advances led by Materials, which is expected to be up by close to 25 percent. Financials follows, up about 23 percent. So it seems as though the bar for the third quarter has been set so low, it’s underground. Therefore, the pessimism that investors have might actually be a good buying opportunity as we actually head into the reporting period.
EQ: So Materials is expected to rebound in a very big way in Q4. What would you look to see their in terms of outlook and guidance to make sure it’s on track?
Stovall: With Materials, the reason we’re expecting to see very weak earnings in the third quarter has to do with weakening demand from China and the dent that is likely to be put into the earnings for mining companies such as copper, iron ore, etc. Also, steel prices are expected to be weakening because of excess production capacity. However, I think a lot of people forget that Materials is not synonymous with metals. Actually, the biggest categories within Materials are chemicals, and our belief is that chemicals should actually post a modest year-over-year gain in the third quarter because of lower feedstock costs–that being natural gas in particular. The feeling is that if we do start to see an improvement in emerging market economies in the fourth quarter and into 2013, then the earnings picture is likely to brighten for the Materials group in the year ahead. So that’s what I would be looking to see.
EQ: In regards to a potential buying opportunity heading into earnings season, do you have any suggestions as what investors should look for to identify actual opportunities versus areas where pessimism is already priced in?
Stovall: I guess that’s the $64,000 question. Prices tend to lead fundamentals, and right now the feeling is that maybe the fundamentals are troughing in the third quarter, but we really won’t be able to know that until we head into the reporting period for the fourth quarter. Since the stock market bottomed in early June and the market tends to anticipate changes in the economy by about six months, that would pretty much be on target for an improvement in economic and in earnings information to be seen in the latter part of Q4 and early part of Q1 of 2013. So from a valuations perspective, even looking at trailing earnings and at what I described last week in my Rule of 20 article, it implies that the market is 10 percent undervalued. Of course, if we are headed toward a continued deceleration in corporate earnings growth in 2013 rather than the re-acceleration that we are currently projecting, then maybe you can “86” the Rule of 20.
EQ: We’ve discussed Apple’s impact on the market before. With the way shares have dipped recently, how much pressure is on Apple to deliver a strong quarter? What kind of implications would it have on the S&P 500?
Stovall: Apple (AAPL) is a very important company within the S&P 500. S&P’s equity analysts have a four-star–or buy–rating on Apple with a current price of around $667. We have a 12-month target at $800. Our feeling is that earnings growth has been pretty strong for Apple, and new product introductions have been fairly hefty for the company, as well as because the company is trading at a reasonable price-to-earnings ratio in our opinion.
With that said, Apple represents close to 5 percent of the market cap weighting of the S&P 500. Adding to that, four of the five largest companies in the S&P 500 are Tech companies, and these four–Apple, Microsoft (MSFT), Google (GOOG), and IBM (IBM)–together represent more than the market weighting of close to 200 companies in the S&P 500. So it just shows you how influential these very large companies can actually be. So it’s important that this industry bellwether report good earnings, not only for itself and its sector, but for the market as a whole.