Equity Sector Views: Lower Earnings Outlooks Spell Trouble

Summary

• Analysts are finally starting to cut year-ahead earnings forecasts. The S&P 500 EPS is 1.2% lower than in early July. The communications, consumer discretionary and technology sectors have registered the largest cuts.
• Energy is the one sector where earnings outlooks have increased, by a whopping 8%. We strongly reiterate our overweight position on energy.

Market Implications

• If the economy remains sluggish during 2H, as we expect, earnings projections will continue to be cut.
• We think the S&P 500 is overvalued now; further reductions in earnings would lead to a renewed selloff and second leg of the bear market.

Allocations Unchanged

We leave our equity sector recommendations unchanged this week. However, we strongly reiterate several previous recommendations:

Underweight Equities – We are underweight equities relative to other major sectors. Given our base case of a slowing economy and possible recession due to the pressure of rising rates, we expect corporate earnings to face increasing pressure during the second half and a renewed downward leg of the bear market.

Overweight Energy – Of all sectors, energy represents the best value. Over the past six weeks, analysts have upgraded their earnings projection for the XLE ETF by a massive 8%. The upgrades come on the strength of 2Q earnings and ongoing commitments to deemphasize exploration and production despite high prices and prioritize returning cash to investors. Even though XLE has rallied 21% since mid-July (versus 7.3% for the S&P 500), it is significantly undervalued relative to its current and projected earnings.

Underweight Homebuilders – We are underweight homebuilders (XHB ETF) due to the sharp slowdown in housing activity, which will depress earnings in 2H. But underlying housing supply/demand dynamics are strong. We view this as a tactical underweight and will look to upgrade this sector as housing stabilizes.

Underweight Consumer Staples – In a contrarian position for a slowing economy, we are underweight consumer staples (XLP ETF). It is a lower beta sector and generally does well in a declining market. But we think it is rich relative to projected earnings and recent free cashflow generation, and the recent earnings season has revealed many companies in the sector are struggling to adjust to higher inflation.

Downward Movement in Projected Earnings

In the past six weeks, analysts have cut their year-ahead earnings projections for the S&P 500 by 1.2% to $210.20 since early July. The implied earnings growth over the next year has dropped from an unrealistic 13.5% to a still-high 10.8%. Earnings for several sectors are also down sharply, including communications, consumer discretionary, real estate, and technology (Table 1). Only the energy and utilities sector earnings have been revised upward.

Earnings for the tech-oriented NASDAQ 100 have also been revised downward, by -3.2%.

Despite the particularly sharp drop in communications (-6.4%), we are marketweight this sector because it is one of the few that is cheap relative to earnings and free cashflow. We expect it will perform roughly in line with the SPX in a down market and outperform as the market recovers.

More Downgrades Ahead

We expect analysts will continue to cut earnings forecasts in coming months as pressures build from inflation and a sluggish economy. We do not have a formal earnings growth target yet. But at this point, we think 5% is reasonable. That would likely lead to another sharp selloff in equities.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)