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: The S&P 500 came within reach of its previous high but couldn’t quite close out the recent correction. With that said, does it look like we’re in good shape to move past that point soon?
Stovall: Well, I think that we have to remember that whether we’re talking about millennial levels on the S&P 500 such as when we went above 1000 and 2000, usually we get up to that point and then retreat. Those levels start acting like rusty doors that require several attempts before they finally break open. I think the same can be said about overhead resistance that was accompanied by high volume at the time they were established. That’s what we’re seeing now at the 2020 level and the 2035 level on the S&P 500. So it might take several attempts before we finally swing open, and I think with some of the concerns that we’re hearing about third-quarter earnings, it’s giving investors reason to retreat from the resistance.
EQ: If that is the case, you looked at a promising strategy in this week’s Sector Watch report to play the rebound. Where does history suggest investors look to when coming off a correction?
Stovall: The interesting thing is that the worst performing sectors and the worst performing sub-industries in the S&P 500 during corrections and bear markets end up being the best performing groups in the six months after the end of corrections. I guess you can say that it’s not a surprise because those companies, sub-industries and sectors that were, in a sense, priced to go out of business but did not are the ones that offer the greatest opportunities.
So it’s not really a surprise to see the Energy, Materials and Industrials sectors be among the better performers because they were the worst ones from this May 21 through Aug. 25 correction.
EQ: The three sectors anticipated to perform best with this approach are also the ones expected to do the worst this reporting season. What are the risks of buying into these groups with expected bad news on the horizon?
Stovall: I think that investors need to realize that in the six months after corrections have come to their conclusions, you’re just bound to get a pop in the worst-performing sectors because they’ve fallen by so much. However, the real question is how long these sectors will stay on top, because you’ve had an awful lot of investors who had purchased these shares at much higher prices. So once those prices approach breakeven for them, investors tend to sell them and move on to more promising opportunities.
Technicians call that overhead resistance, so sometimes it takes a while for that resistance to be worked through. Also, I think investors are anticipators and that’s why Energy, Materials and Industrials are expected to be the worst-performing sectors in terms of earnings this quarter, but if you look out to the fourth quarter of this year and all four quarters of next year, it appears to us currently that the S&P will be tracing out a V-shaped recovery in the year-over-year percent changes in earnings. So I think investors may be beginning to look beyond the weakness of this third quarter to focus on the opportunities that an improvement in expectations will offer.
EQ: Speaking of earnings, the market looks to be headed higher despite all the talk of a projected earnings recession and the implications that it brings. Does that suggest that investors are not worried about that happening?
Stovall: I think investors are believing that a lot of the company managements are crying wolf in the guidance that they provide to the analysts. We know that the actual earnings percent changes have exceeded the estimates in 14 of the last 14 quarters by an average of 4 percentage points. So I think investors are being a bit cynical right now. They’re essentially saying that while estimates are calling for a near 5% decline, companies will probably beat as they have done in previous quarters, and perhaps even poke their heads into positive territory rather than the steep decline in earnings expected for this quarter.
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