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 market has had a pretty rough week thus far, adding to the downward move we’ve been experiencing since mid-September. At the same time, expectations for Q3 earnings is very encouraging as we head into the reporting period. How should investors be approaching the market at this time?
Stovall: I think they’re approaching the market realizing that Q3 earnings are currently forecasted to rise 6.2%, which is similar to where we were at the beginning of the second quarter reporting period, and true to fashion, company management did a great job guiding expectations lower, so that they could end up beating estimates, and certainly, they did because the S&P 500 posted a 10.3% gain in Q2. So should the same thing happen this time—and usually, the actual earnings beats the estimated earnings by anywhere from 2-4%–we could see another double-digit gain on the horizon.
EQ: Will that gap narrow or widen as earnings growth heads into the double-digit territory?
Stovall: That range has stayed fairly consistent. That 2-4% is a pretty wide wage to begin with, and a couple of quarters ago, we surpassed the 2% threshold. The most recent quarter, we were at the upper-end of that range. Who knows? Maybe we end up breaking above that range and show earnings growth that is equivalent to what is currently estimated for Q4, which is a more-than 11% increase in operating earnings.
EQ: The Q2 reporting period posted EPS records, but operating and as-reported margins also set records. Could this continue as well for Q3?
Stovall: I think the margins are still looking pretty good. I think it’s because we have a very low interest rate environment, and companies have been doing a very good job maintaining low-cost structures, and should we start to see a pickup in revenues because of this operating leverage, it could actually end up pushing operating margins lower and not drag them down as companies look to expand their operations.
EQ: On a sector basis, Health Care (11.1%), Materials (14.1%), and Telecom (12.0%) are the only three groups that are expected to post double-digit EPS growth. What are the individual drivers for these groups?
Stovall: In Health Care, we look for the Biotech industry to post the strongest sales growth, primarily because of the recently approved drugs. These drugs are looking at sales that are not just in the millions, but in the billions of dollars. So our belief is we can see several biotech companies that are posting very strong revenue and earnings numbers for this Q3. Also, we believe the strong price performance for the Health Care Facilities (hospitals) is going to be a result of the health care reform law. Eight million Americans obtained health insurance through these exchanges, and 5 million additional people enrolled for Medicaid.
So hospitals and other facilities began seeing benefits of more insured patients in the second quarter this year, and we just think that’s going to continue.
In Materials, it’s really dominated by the Chemicals companies. We think they will benefit from increased production and cost-control efforts. We also see a return to relatively low natural gas prices after the higher prices we’re seeing this past winter. The higher production stems primarily from strong growth in emerging markets in Asia.
Finally, we see Telecom Services benefitting from more macro factors, such as the strengthening of the U.S. economic growth, firming jobs landscape, improving consumer sentiment, and still favorable interest rates. We also anticipate elevated capital expenditures by Telecom Service providers, in an effort to support greater penetration for mobile devices and the need for more data.
EQ: Telecom’s expected growth rate for Q3 isn’t skewed by Sprint (S) as it has in previous quarters, correct?
Stovall: That’s correct. Because of the removal of Sprint from the index, it actually freed up the earnings. Sprint had been operating at a loss, so by removing them, it made the numbers from the prior four quarters look exceptionally strong. This quarter, Sprint is out, however, the third quarter earnings strength is also likely to benefit from Verizon Communications’ (VZ) purchase of the remaining 45% stake of Verizon Wireless, which was owned byVodafone (VODA).
EQ: Consumer Discretionary, and to a lesser extent Consumer Staples, are expected to post their weakest quarter of the year in terms of year-over-year growth. Are we seeing a slowdown in the consumer sectors after an extended run or is this just a normal lull?
Stovall: I think we’re seeing a slowdown because the potential headwinds for the third quarter include a stronger dollar, a soft back-to-school season, as well as advertising and box office sluggishness. Remember, Consumer Discretionary is not just automobiles and homebuilders; it’s also media companies. Overseas, we also see some pockets of weakness, such as in Macau for Casinos and Gaming, and then in Europe for the Automobiles industry.
For Consumer Staples–which are your foods, beverages, and tobacco kinds of companies–even though we’re seeing low levels of inflation, we believe that pricing power has been limited because of intense competition. Also, we’re finding that a lot of Consumer Staples companies have been increasing their marketing expenditures, which we think could end up shrinking profit margins.
EQ: The expected direction of the dollar’s strength going forward will have varying implications for each sector, primarily for companies that generate sizable overseas revenue. What should investors look for when considering how currency affects their equity investments?
Stovall: Well, first off I think trying to quantify how much currency exposure these companies might have is a very challenging thing to do. S&P Dow Jones Indices recently published a report, which can be found free of charge on www.spindices.com, in which they showed which sectors had the greatest international exposure. Energy, Materials, and Technology had foreign sales in excess of 50%. That said, however, the index group also reminded us that companies aren’t required to tell us specifically where their revenues are acquired. It’s trying to ask a fisherman to name their favorite fishing hole. People are going to be reluctant to do that. So only about 50% of the companies in the S&P 500 give enough information for us to guestimate where the foreign sales take place.
Also, I think investors need to realize that many times companies end up hedging their dollar exposure. So even though they might end up having more than 50% of their revenues coming from overseas, it might not adversely affect their earnings, nor will it provide a tailwind should the dollar be declining, because they just try to offset it with hedging activities.