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 European summit has begun, and depending on who you ask, the pressure on this meeting is enormous. Yet at the same time, expectations for significant progress is low. What are your thoughts on the potential impact of the summit?
Stovall: I do think the pressures are high but the expectations are low for the summit. Some are hopeful that Germany will be pressured into softening their stance of austerity as well as being more agreeable to some sort of joint bond effort where the European Union floats bonds that are used to pay off the debt of the sovereign members, rather than the sovereign members borrowing to pay off their debt. At this point, it's too politically unacceptable for German Chancellor Angela Merkel to allow. So as a result, I think people might be disappointed by the summit's outcome.
EQ: The first half of the year closes out this week, and surprisingly the S&P 500 is on pace to show a gain of about 4 percent. As good as the first quarter was for investors, the second half was arguably just as bad. With the third quarters of election years being historically the worst performers, should investors expect the market to get worse before it gets better?
Stovall: I wouldn't necessarily say that it's going to get worse, rather that I just wouldn't expect very much out of the market over the third quarter. Just as politicians don't like to be too committal, neither does the market, at least when we are leading up to the presidential election. Since World War II, the average price change has been a gain of only 0.1 percent for the S&P 500 in the third quarter of a presidential election year. What's even more confusing is the batting average--the frequency with which the market rises in the quarter--which is only 50 percent.
So basically, the market might go up or it might not go up, but I think investors will likely be just sitting on their hands and listening to the conventions, speeches, and political advertisements to try and figure out what is going to happen when the election actually occurs. However, if there is some daylight after the dawn, what we find is that the fourth quarter of presidential election years has seen the S&P 500 gain about 2 percent on average. More impressive, however, is its batting average (frequency of advance) at 81 percent since WWII. Of course, it's important to remember that history is a guide but it's never gospel.
EQ: In this week's Sector Watch report, you noted that S&P Capital IQ recommended shifting into some more cyclical sectors like Technology and Consumer Discretionary. Assuming that the third quarter does underperform, is this a good opportunity for bargain shoppers?
Stovall: S&P Capital IQ has had a positive outlook on Consumer Discretionary for quite some time, and we recently elevated Information Technology to join it. The third quarter is usually a very weak for cyclical stocks, so if investors do have their eyes on both sectors, it could represent a good buying opportunity. Since 1989, which is as far back as we have sector-level data, the worst performing sectors in Q3 were basically the cyclical sectors. While the S&P 500 was down 1.1 percent on average, the worst performing sector was Materials, down 3 percent. Consumer Discretionary was down 2.7 percent, and Industrials was down 1.6 percent. Information Technology also declined, but slightly less than the S&P 500. However, based on a combination of very low P/E ratios, projected growth versus current earnings, as well as new product introductions, we feel now could be a good time to start accumulating and overweighting the Technology sector.
Not surprisingly, the best performing sectors on average in the third quarter are the defensive groups: Consumer Staples, Healthcare, and Utilities. And just as a lot of people tend to forget the fifth Beatle, many people tend to forget the fourth defensive sector: Energy. That too has historically posted a slight advance in the third quarter of each year.
EQ: Utilities is a defensive sector that you have underweight. Why is that?
Stovall: We have an underweight on Utilities for a couple of reasons. It has been a very strong performer--by far the best performing group in 2011, up close to 20 percent while the S&P 500 was flat. Usually, defensive stocks do better on a relative basis. So if the market falls, then defensive groups fall by less. On the other hand, if the market rises, Utilities usually rise by only a small amount. Rarely do we have Utilities up 20 percent when the market is flat. So we believe that valuations are stretched at this point, whether you're looking at P/E for 2011 or 2012 earnings, or looking at the P/E growth rate for the coming five years. In addition, we expect Utilities to see a near 5-percent decline in earnings in 2012, and have earnings growth that is only one-third of what is expected for the S&P 500 in 2013. It's a combination of being overvalued, and at the same time, showing little-to-no earnings growth over the coming period.
EQ: The $1.2 trillion in automatic federal budget cuts has shifted back into focus recently, with reports that Congress is trying to push the deadline out to March instead. If this does happen, would the extended period of uncertainty do more harm than good for the market?
Stovall: It does extend the period of uncertainty, but at the same time, it will reinforce the impression of business as usual for Congress, which means all they're doing is kicking the can down the road. What it really indicates is nobody knows what is going to happen with the election. It also means that they assume not much will be done during the lame-duck period from the elections to the end of January when members of Congress are sworn in. So by delaying the cuts they're Congress is giving itself more time to pass some laws that might undo the sequestration scheduled to take effect on the very first day of 2013.
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