Not only has earnings growth been strong but, for the most part, it has also been stronger than expected and this has given sustenance to the bull market.
Earnings growth remains critical but its feature may no longer be its unexpected strength because earnings are now surprising on the downside. Although this is primarily due to the sub-prime fallout and its impact on the banks, the earnings disappointment has not been confined to the banks. The US provides the clearest and most timely example of this.
Most of the companies in the S&P 500 have now reported their results for the third quarter. Earnings surprises for 5 out of the 10 sector groupings for the S&P 500 (the 5 being; financials, consumer discretionary, energy, industrials and materials) are negative.
As the chart shows, the bottom line is that, for the S&P 500 as a whole, earnings growth is falling short of the consensus expectation held not just at the start of third quarter but also at the end of it, i.e., almost right up to the time companies started reporting. Not only are earnings surprising on the downside, they are actually lower today than a year ago. This is the first drop in earnings for the S&P 500 in this cycle.
Default risk is on the rise. Yield spreads, especially at the high yield end of the market for corporate debt, are widening again. They narrowed after the Fed cut the Funds rate by 50 basis points in September but the Fed’s second cut in rates - October’s quarter point cut - did little to arrest the widening. If anything, the spreads widened further on the cut thus suggesting that it was not enough and that more cuts are to come.
After four years in which earnings have continued to surprise by their strength, there is a growing risk that earnings could now surprise by their weakness and drain away some of the sustenance that has kept this bull market going through thick and thin.
Given the risk, the options are: do nothing, take out insurance, cut the momentum plays, look for value. Let’s take the latter first in the context of the UK equity market. In view of its exposure to the global economy, the FTSE 100, with 65 to 70 percent of its sales derived overseas and geographically well spread, may be as good a gauge as any of how the winds of change might blow for global equity markets.
As the chart below shows, defensives (e.g., Pharmas, Food Producers, Beverages, Tobacco, Utilities), growth (e.g., Telecoms, Media, Technology) and financials (e.g., Banks, Insurances, Real Estate, General Financials) have been left behind by the cyclicals, i.e., mostly Mining and the industrials. To date, defensives, growth and financials have performed more or less equally well - or poorly depending on your take - since the Spring of 2003. At times one group has outperformed the others but over time there has been roughly similar progress. Is there value in and amongst this peer group?
Let’s take the defensives and focus, say, on a defensive growth sector like the Pharmas, which has been underperforming for a long while. The feature here, as the chart on the next page shows, has been the de-rating of a sector that has typically sold at a p/e premium to the market average. The market’s judgment is that the Pharmas have gone ex-growth. The news flow has been a constant source of disappointment. The erosion of the p/e premium reflects this. However, the yield on the sector is at a premium to the market average and the premium is increasing. Here is a ‘high yielder’ in the making.
Other defensives like Beverages, Tobacco and some of the Utilities are selling on p/e premiums to the market average but then some of these, like Beverages, are virtually growth plays. At a time when the risk is on the downside for earnings growth, a defensive growth is a sought after commodity.
With the financials, we’re into the realm of the ‘known unknowns’. For the banks, the problem is mortgage backed securities; the unknown is the magnitude of the damage inflicted on the Banks and the extent of the write-offs.
Valuations reflect the known but not the unknown. Can earnings expectations be trusted? Concern is also growing about the prospects for UK residential and commercial property, which is where mainstream banking is greatly exposed. The ratings in the Bank sector look attractive but what you see may not be what you necessarily get.
Onto growth and sectors like the Telecoms, Media and Technology. Media has been disappointing. Much restructuring has taken place in the sector but the recovery over the past year has turned into a damp squib. On the other hand, the Tech sector, the software side of it, has made slow but steady progress. However, the big mover has been Telecoms.
The Telecom sector, spearheaded by Vodafone, has joined the momentum bandwagon. Until recently, holding Vodafone brought investors nothing but aggro but the new found momentum for the shares has meant they have performed almost as well as the Miners over the past 14 months.
Fundamentals remain positive. Also, the shares still sell on a yield premium to the market average, though less so than before, and they’re not the only Telecom shares that do. The shares of BT Group sell on a yield premium too. There’s value in Telecoms!
Momentum has been the name of the game. Fundamentals have mattered but momentum once acquired has persisted. Mining is the obvious example and there are others. Mining is no longer cheap. The sector now trades on a prospective p/e ratio that is slightly above the market average. However, investors like the super-cycle story. Thus, while the momentum bandwagon may not yet be for turning, it could be time to scale back on a big bet here though that doesn’t mean having no exposure.
An aggressively underweighted position is a big bet. You never know when the market will re-rate the shares of a sector that has fallen out of favour. The banks are oversold. The shares are among the highest yielding in the UK equity market and are candidates for an eventual re-rating.
Given the risks, being defensive means moving closer to benchmark weightings on sectors. We’re not calling the top of the bull market. The global economy still has a look of sturdiness about it, which partly accounts for the inexorable rise in the oil price (aren’t we at the pain barrier yet?). But global economic growth was expected to slow before the sub-prime fallout. And now that the banks are losing the capacity to finance growth, the uncertainty surrounding earlier forecasts for economic growth and corporate earnings has increased.
Allowing for the risks to the earnings outlook, valuations in the major equity markets are still satisfactory. But a spell where the market trades sideways for a while could now be on the cards. While the prospect of earnings downgrades could limit the upside potential for equity markets, the prospect of further cuts in the US interest rates, as well as likely cuts in the UK and the eurozone, could limit the downside.
A consolidation phase would provide the incubation period for the next phase of market leadership in the next stage of the bull market. Today’s high yielding equities, like the banks, may well be among the new leaders. But for now the chart probably says it all. It’s time for insurance! And not time for big bets!
