As Sam Sees It: Will the Market Finally Bust Out of Its Earnings Slump?

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: With the Fed largely expected to stay on the sidelines until December, the market’s attention has shifted to Europe, particularly with Deutsche Bank’s (DB) contagion risk and the ECB’s own taper tantrum. Are these headwinds strong enough to derail our current bull market?

Stovall: I don’t think so because I don’t believe that they’re going to lead to global economic recession. People frequently say that bull markets don’t die of old age and I tend to agree. I think they typically die of fright, and what they’re most afraid of is the potential for recession. So I think investors will be looking at the taper tantrum occurring in Europe to try to ascertain whether that could end up leading to recession, but I don’t think it will.

As it relates to Deutsche Bank, the question is how much will they be penalized by the Department of Justice. That’s what’s causing investors to be on edge because they are just not aware what that penalty amount will be. That’s why on Friday, Sept. 30, the market jumped quite a bit because there was a rumor that the DOJ had come to an agreement with Deutsche Bank regarding the penalty amount. So I don’t believe that it is anything that is going to be a long-lasting effect like Lehman was.

EQ: Third quarter earnings reporting season kicks off next week. What is the likelihood that the S&P 500 finally break out of its prolonged earnings recession?

Stovall: We think that the likelihood is very high. What we have found is over the past 18 quarters, the actual earnings have exceeded estimated earnings by 3.5 percentage points. So with third-quarter earnings expected to be down by less than 1%, if history were to repeat itself—and obviously there’s no guarantee it will, we could see earnings for the S&P 500 up 2.5% when all companies have ended up reporting. That would end up breaking the string of successive quarterly declines and put us firmly into the recovery from this earnings recession.

EQ: What is the significance of finally breaking out of the earnings recession—which is estimated to have bottomed in Q1—from a psychological, economic or even fundamental perspective?

Stovall: I think, certainly from a psychological perspective, coming out of the earnings recession would suggest that the economy is improving to the point where both earnings and revenues are on the upswing. We do know for certain that companies are reducing the amount of share buybacks, as a result, the earnings recovery ends up being the result of economic improvement rather than accounting shenanigans.

EQ: This is the first earnings season for the newly created Real Estate sector group. What was the reasoning for breaking this out into its own group?

Stovall: Well, real estate is regarded by many investment advisors as being a distinct asset class. Whether you look to such books as Asset Allocation by Roger Gibson or The Intelligent Asset Allocator by William Bernstein, both books look to real estate as distinct asset class and not a mere subset of the Financials sector. So I think S&P Indices decided it was time to break out Real Estate into its own sector, even though it, along with Telecom, Materials, and Utilities each represent less than 4% of the weighting of the S&P 500.

EQ: Financials is expected to be among the better performers for Q3 with a projected 5% in EPS growth. What are the expected key drivers for this group?

Stovall: I think the key drivers will be a continued reduction in loan loss reserves because many of these banks are actually showing an improvement. We’re seeing an increase in loans outstanding. We’re also seeing improvement in the loan quality. So basically with these companies, in a sense, proving to the regulators that they are shoring up their balance sheets, it will allow them to reduce the money required to be held on the side for potential bad loans. It also allows them to increase the dividends that they could be paying to shareholders. In general, the picture is improving for the Financials sector, not only on a price basis, but also on an earnings basis.

EQ: The Energy sector is still working through its troubles, and is expected to post a decline of 65.5% in EPS for Q3. With oil prices not forecasted to surge much higher for the foreseeable future, what can we expect from this group?

Stovall: We could actually expect a pretty substantial turnaround in 2017. In 2016, our expectation is we’re going to be seeing a 60%-plus decline morph into a more-than 300% increase in 2017. Granted, when you see a slight improvement from a dramatically reduced number, that’s why we end up with a very high percentage gain.

What we’re finding is that Energy, which had served as a headwind for both 2015 and 2016, is expected to be a tailwind in 2017. The reason for the turnaround basically is because much of the reduction in capital expenditures and much of the impact from falling oil prices will have already worked its way through the system. Now, as we head into 2017, the improvement in oil prices will then start to benefit the bottom line. There is a 93% correlation between S&P 500 Energy earnings and oil prices, so eventually the improvement in oil prices will work its way into the earnings picture.

EQ: Which other sectors should we be keeping a close eye on during Q3 reporting season?

Stovall: Well, seven of the 11 sectors are expected to post positive earnings in this third quarter. It certainly would be good to see if we end up with even more of them. Surprisingly, Utilities is among the better-performing sectors from an earnings forecasting perspective, and I think that’s because of weather that is more conducive to using additional power, and not necessarily due to household formation.

I think we’ll probably end up seeing about a 5% gain in Utilities earnings, which also benefits from the lower fuel costs. But pay attention to the guidance because it looks like Utilities will be among the weaker growers in 2017.

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
DB Deutsche Bank AG 7.92 0.02 0.25 5,034,828 Trade

Comments

Watchlist

Symbol Last Price Change % Change
AAPL

     
AMZN

     
HD

     
JPM

     
IBM

     

Blockchain in Fintech - Discussion at the EU Parliament

From the recent Blockchain For Europe Summit in Brussels: Panel on Financial Market Infrastructure