EQ: Alcoa kicked off the Q3 earnings season with a disappointing miss, but investors seemed unmoved by the company's results. Given the challenges that the company, and its stock price, has endured over the last few years, has the company lost its reputation as a bellwether for the market?
Stovall: I don't think that Alcoa (AA) necessarily was a bellwether for the market as much as it simply sounded the starting gun, if you will, for the quarterly earnings reporting season. Basically, you always had some companies that would report quarterly results before Alcoa, but most people on Wall Street looked to Alcoa as the first real corporate release of that quarterly season just as New Hampshire used to be the first primary. Many other states tried to move their caucuses or primaries ahead of New Hampshire so that they got the symbolic starting point for the election.
EQ: So there’s no real connection between Alcoa’s performance and that of the broader market?
Stovall: There have been times in recent memory when Alcoa has done poorly, and yet the market advanced through the quarterly reporting period. Then there are other times when Alcoa did well but stocks declined during the overall earnings reporting period. I don't know what the actual track record is for a beat versus a miss, and then comparing it to the price performance of the market for the subsequent two months, but I at least have not heard much correlation between the two.
EQ: What are a few bellwether companies that you think investors may want to pay closer attention to during this earnings season?
Stovall: Certainly, you have to pay attention to the behemoth banks to find out about loan quality, direction of loan demand, as well as finding out more about the housing market with mortgages in particular. Also, some of the consumer companies are going to be very important to watch within Consumer Discretionary to give us an idea as to what the retail consumer is doing. Are they being affected by stubbornly high unemployment? By still-high oil prices? By concerns over a double-dip recession? And also I would pay attention to multi-national firms in general, and their commentary on global economic growth. Is it still expected to be robust in the emerging markets? Or have all areas of the globe begun to slow?
EQ: The market seems to be most pessimistic on Financials, and with good reason. Do you think this sector might be best positioned to surprise investors? If not, is there any sector that might fit that categorization?
Stovall: The sectors that were either beaten up in price or brought down most dramatically in terms of earnings forecasts are the ones that could end up surprising investors the most because so much pessimism has already gone into the share price or the earnings expectations. S&P Capital IQ forecasts that third-quarter earnings would be up 17 percent back in early July, but now consensus estimates forecasts only a 12.5 percent increase in operating earnings.
Since the April 29-high through Oct. 11, the S&P has fallen 12 percent. What's interesting is that among the worst performing sectors price-wise are Financials, down 24 percent; Energy and Materials down 19.9 percent and down 19.6 percent, respectively. While Energy and Materials has posted the second and third-deepest declines since the market peaked in late April, they are expected to show the strongest earnings growth for this third quarter. Energy is expected to be up 51 percent and Materials to be up 23 percent. With those two sectors, I don't think it's investors concerned about third-quarter earnings as much as I believe it's worry over a global economic slowdown and what that could do to future earnings for those two sectors.
EQ: One sector that has been showing relative strength is Consumer Discretionary, which is interesting given that the current recessionary environment would suggest that people spend less on discretionary goods. How have companies in this space been able to hold up so well?
Stovall: I've come to the conclusion that the Consumer Discretionary sector is not as cyclical as some people assume them to be. First off, the beta for this sector is only 1.1, as compared with 1.0 for the overall market. So it's ever so slightly higher than that for the S&P 500. In addition, one in three industries within the Consumer Discretionary sector have a beta equal to or less than that of the overall market place. Some groups such as Restaurants--which actually is the largest industry within the Consumer Discretionary sector at 14 percent--has a beta of only 0.6 because the biggest component is McDonald's (MCD), which consumers trade down to when they feel that they cannot afford a higher-end restaurant. Basically, you have to realize that not all groups within Consumer Discretionary are going to be that volatile to begin with.
I think a question that could also be directed to all companies in the S&P 500 is, “How do we end up with 12.5 percent earnings growth when real GDP for the third quarter is only expected to be up less than 2 percent?” As a result, investors may be thinking to themselves, "Gee, either they're cooking their books or they're actually getting earnings growth from elsewhere."
Specifically, for the third quarter of 2011, we think real GDP will be up 1.6 percent. So where could companies be getting their earnings? First off, companies are still engaging in cost reductions. That's why unemployment is remaining stubbornly high. Also, companies are continuing to engage in share buyback programs. Lastly, we have acknowledged the fact that about 50 percent of the revenue for companies comes from overseas operations. When you realize that the whole world is expected to see 3 percent GDP growth in 2011 as compared with 1.6 percent for all of the U.S., you realize that emerging markets are growing at about a 6 percent rate, frontier nations at about a 2.5 percent rate, and its only the developed economies around the globe that are showing the greatest amount of weakness.
EQ: Any additional final thoughts?
Stovall: What I can say is that in terms of revenue growth, S&P Capital IQ is expecting the S&P 500 to post an 8 percent increase in revenues in the third quarter on a year-over-year basis. That is equal to what we saw in the first quarter, but down from the 11 percent we saw in the second quarter. Revenue growth is expected to be stronger this quarter than in all quarters in 2010, and certainly all quarters of 2009, but not the strongest so far this year.
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