As Sam Sees It: With No More Room to Cut, Companies Are Finally Forced to Grow for Value

Sam Stovall |

Sam Stovall Chief Equity Strategist for S&P Capital IQEach week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: In this week’s Sector Watch, you said that if Q3 is indeed the toughing quarter, Cyclical sectors are the way to go. This would also mesh well with the adage of the Best Six Months, correct?

Stovall: Yes, it is. There are two parts to the question in that we do expect some of the cyclical sectors to show the best earnings gain in the third quarter, even though we do think that the third quarter will likely be the low point for the S&P 500 between now and the end of 2013. Specifically for the third quarter, we expect Financials to show a 9.5 percent increase from year-over-year operating results, Consumer Discretionary showing a 5 percent gain, and Industrials show a 4.4 percent increase as compared with a 1.1 decline for all of the S&P 500. It’s interesting that it’s coming at this time because we do talk about the two halves of the year where November through April tends to be much stronger than the May through October period. The Stock Trader’s Almanac has written about this extensively.

Since 1945, the S&P 500 has gained an average of 7 percent from November through April, but only a little more than 1 percent from May through October. We also found that the S&P 500’s performance from November through April has outperformed the subsequent May through October performance by more than 70 percent of the time. So there is certainly a statistical and seasonal anomaly in which stocks just do better in these winter months. If history is going to carry through as well, and there’s no guarantee it will, investors are probably better off gravitating toward the cyclical sectors rather than the defensive ones.

EQ: In addition to the cyclical sector ETFs, there’s also the S&P 500 High Beta Index that could help investors to target the more aggressive areas of the S&P 500. Can you talk about the ETF for that?

Stovall: There are two subsets of the S&P 500. The S&P 500 High Beta Index are the 100 stocks in the S&P 500 with the greatest trailing 12-month standard deviation or volatility. The S&P 500 Low Volatility Index are the 100 stocks with the smallest trailing 12-month standard deviation or volatility. So you could play this seasonally strong and seasonally weak phenomenon by being in the S&P 500 from November through April, and then be in the defensive sectors of Consumer Staples and Healthcare from May through October. However, if you prefer to be in either just risk on and risk off, then you’re better off being in the S&P 500 High Beta Index from November through April and then be in the S&P 500 Low Volatility Index from May through October.

Over the long haul, meaning since 1990, this would have provided investors with more than 11.5 percent for the High Beta Index versus 6.9 percent for the S&P 500. During the summer time months, the S&P Low Volatility Index was up 2.8 percent versus only a 1 percent gain for the S&P 500. Investors can invest in ETFs that replicate the S&P 500 High Beta and Low Volatility Indices with the PowerShares S&P 500 High Beta (SPHB) and PowerShares S&P 500 Low Volatility (SPLV), respectively.

EQ: What are some of the bellwether companies that you’re watching closely for this reporting season?

Stovall: If indeed the third quarter is likely to be the troughing quarter for the S&P 500 earnings, then first off, with almost all companies, I’m looking very closely at what kind of guidance will be offered by company management. Frequently, guidance is not really freely given by company management, but whatever hints we can get will be very helpful. In the latter part of the week, we have JPMorgan (JPM) and Wells Fargo (WFC). Next week, we have a lot of banks and American Express (AXP) reporting. For whatever global companies will be reporting, I want to make sure the guidance they offer will confirm that we are likely to be seeing a trough of this quarter or fairly soon. That would substantiate the reason behind the markets bottoming in June of this year since stocks typically anticipate changes to the U.S. and global economies by about six to 12 months.

EQ: There have been a few early surprises, relatively speaking, so far in Q3 earnings but have had little impact on the market. Do you feel that investors are already looking past what companies are going to say for Q3 and focusing more on what might happen in the coming quarters?

Stovall: I think that’s possible because any time you have an earnings reporting period, it’s already ancient history according to investors. S&P Capital IQ consensus estimates are calling for a 1.1 percent year-over-year decline in operating earnings for the third quarter of 2012 for the S&P 500 with five of the 10 sectors posting growth. The laggards are likely to be Energy, showing a decline of 16.8 percent and Materials with a decline of 19.8 percent.

It is still very early in the reporting companies, with only 30 companies reporting so far (as of Oct. 10 before the market close). However, with 60 percent of these companies having beaten their estimates, that falls below the 10-year average of 62 percent. Also, revenue growth for the third quarter is expected to come in fairly lean at 1.1 percent. So I think investors will be paying attention to the third quarter reports but focusing more so on what they’re likely to be seeing in the coming quarters of this year and next year.

EQ: In previous earnings seasons, we’ve discussed the margin between Wall Street expectations and actual results. Has that margin been declining?

Stovall: Yes, it has. The margin on average was 7.5 percentage points up until the first quarter of 2012. Yet, in the second quarter of 2012, the difference was only about 2 percentage points. S&P Capital IQ is expected close to a 1 percent decline in earnings for the second quarter and we ended up getting a little less than a 1 percent advance. As the quarters have progressed in this economic and earnings cycle, we have found that the spread between expectations and reality has been narrowing. What I think it’s showing is companies have already cut to the bone, so there’s not a lot of savings that can still be wrung out of operations. I think companies will have to look toward revenue growth as well share buybacks to grow earnings in this and future quarters.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
AXP American Express Company 63.82 -0.47 -0.72 851,231
FBNI Furniture Brands International Inc. n/a n/a n/a 0
JPM JP Morgan Chase 66.11 -0.25 -0.37 3,311,012
WFC Wells Fargo & Company 45.00 -0.09 -0.20 8,572,609

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