by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

  • Correlations have plunged, leading to wider sector dispersions and a “cancelling out” effect on volatility
  • Earnings are moving from a four-quarter recession to strong double-digit growth in 2017
  • Forward valuation looks reasonable when looking through an inflation-filtered lens

 

Much ink spilled these days—including by yours truly—tends to be of the macro variety. This is for good reason as studies have shown that macro forces have been greater determinants of asset class performance than traditional underlying fundamentals. This was corroborated by high correlations among and within asset classes. But this has recently changed; and we’ve been arguing that traditional fundamentals like earnings, valuation and (as always) sentiment will be more dominant market drivers.


Volatility low, but for an interesting reason

Correlations have come down markedly, especially among sectors. In fact, one of the reasons why volatility has been so low is due to the “offsetting” effect. The spread between sectors’ performance has widened, which means for sectors displaying strength, there are offsetting sectors displaying weakness.  Year-to-date we’ve seen strength in Technology and Consumer Discretionary in particular; which has been offset by nearly-equivalent weakness in Energy and Telecom Services. In essence, sectors have been washing each other out, resulting in suppressed volatility.

One way to think of it is that the market has gone from a “risk on, risk off” environment (with high correlations) to a “Trump on, Trump off” environment (with low correlations). And it’s not just the performance of sectors which has diverged—the spread between the winners and losers in terms of earnings growth has widened out.

Earnings: from recession to recovery

The chart below looks at the trajectory for S&P 500 earnings growth back to 2012 and including estimates for the next four quarters. From the earnings recession—which spanned four consecutive quarters and ended in the third quarter of 2016—earnings are expected to rebound back into double-digit territory in 2017.

S&P Earning Growth

Source: Thomas Reuters, Yardeni Research, Inc., as of February 9, 2017. 4Q16-4Q17 based on estimated earnings growth.

The chart below looks at quarter-by-quarter estimated earnings growth for the five quarters beginning in last year’s fourth quarter (its reporting season is still underway). As is abundantly clear, the turn in the energy sector from deep negative territory in 2016 to massive year-over-year growth in this year’s first half has been the largest contributor to the S&P 500’s earnings rebound.

S&P Sector Earnings

Source: Thomson Reuters, as of February 9, 2017. *Prior year’s earnings are negative.

Beat rates underwhelming

As noted, fourth quarter earnings (bottom line results) are still being reported, although we are through about 75% of the season. To-date, 68% of S&P 500 companies have beaten expectations, 11% have matched, and 20% have disappointed according to Bloomberg.  That “beat rate” is in line with historical averages.  The revenue (top line results) story is a bit uglier.  Only 48% of companies have beaten expectations, while 52% have disappointed; decidedly worse than the historical average.

The three top sectors in terms of the beat rate have been Technology (87%), Health Care (80%) and Financials (76%). This is a perfect dovetail with our sector recommendations which have those three sectors as overweights. Bringing up the rear in terms of beat rate have been Telecom Services (25%), Utilities (33%) and Real Estate (47%)—which happen to be our three underweight recommendations.

Valuation reasonable on forward earnings

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