Hundreds of big companies will be reporting their quarterly earnings in the next few weeks. The results can help to influence the near-term directional trends of the stock market. As can be expected, companies that beat projections will likely see their prices appreciate further, justifying the recent strong stock market rally. However, companies whose earnings projections fall far short of expectations will be punished with sharp sell-offs. If enough companies fall short, this can lead to the correction that some of the bears have been warning.
Whether these companies have a good quarter or may not matter, at least from an intermediate-to-longer term outlook. The stock market relies more on the expectations of the US economy, and specifically on the outcome of the COVID-19 pandemic, and the reopening.
According to FactSet, valuations show investors have raised the bar for many companies. S&P 500 Index is now trading at over 22.65 times their projected earnings over the next twelve months. The projected SPX earning is trading well above the five-year average of 17.84 times. The optimistic earnings projection comes at a time when analysts estimate profits for SPX companies fell 6.8% during the fourth quarter from the previous year and nearly 13 % for the entire year (2020).
Despite high historical valuations, troubling signs about the accelerating toll from the coronavirus, and the weaker than expected job growth trend, the market seems to be looking past the pandemic. Investors may be counting on strong earnings starting as early as the first quarter of 2021.
Technical speaking, stocks and cyclical sectors tied to the economy tend to discount business cycle turns months and quarters ahead of the actual outcome. Economically sensitive sectors have performed relatively well.
So, does this imply the stock market may be anticipating the official end to the Feb 2020 recession? And if so, are they already expecting the US economy to have already transitioned toward the early phase of the business cycle recovery/expansion?
In the past quarter alone, the S&P Energy sector (XLE) has rebounded 32.30%, Financials (XLF) has jumped 22.93%, Materials (XLB) has increased 15.96%, and Industrials (XLI) has gained 15.85%. Even with some of the larger S&P sectors such as Technology (XLK +10.51% Quarter to Date), Healthcare (XLV +8.36%), and Consumer Discretionary (XLY +8.18%) underperforming SPX, the four outperforming S&P sectors accounting for 24.58% of the total S&P 500 market capitalization have dramatically outperformed the SPX Index (SPX +11.10% quarter to date).
The US business cycle has four phases - early, mid-cycle, late, and contraction/recession. US economy probably entered the late-expansion phase of its business cycle during 2019. It then quickly slipped into a recession phase during Feb 2020 as the pandemic, and the subsequent lockdowns shut down the economy. Although every business cycle is different, well-defined sector rotations have repeated over the years. Economically sensitive sectors tend to be the strongest during the early phase of the business cycle. The early-phase also produces the steepest price jump and the highest absolute performance for investors.
Based on the longer-term relative performances of the S&P sectors across the US business cycle, the early phase of economic growth or recovery favors the Financials, Industrials, and Materials as they tend to outperform. Other cyclical related and interest rate sensitive sectors such as Consumer Discretionary, Technology, and Real Estate also tend to outperform their peers. Energy, Healthcare, and Utilities tend to underperform during the early-to-mid phases as the economy begins to gain traction. A brief review of the enclosed fourth-quarter price charts shows investors may be pricing in a sustainable US recovery/expansion during 2021.
As the economy moves beyond its initial stage of recovery, the economic growth rates will start to moderate, and the leadership roles of interest rate-sensitive sectors begin to taper. Investors will turn to the mid-cycle sectors as these sectors take on leadership roles. It is the longest phase of the business cycle, longer than any other stage. The mid-cycle leaders are the Communication Services and Technology sectors. Investors are interested in investing at this stage of the cycle because (1) they are more confident the economic growth cycle is sustainable, and (2) the duration of the mid-cycle expansion/recovery cycle is long, allowing them time to participate.
Another interesting point worth mentioning is although Technology has lagged the market during the fourth quarter, the secular growth sector only marginally lagged the SPX Index after significantly outperforming its peers during the first half of the year. Technology names such as FAANG + MSFT may very well be consolidating their gains before resuming their primary long-term uptrends.
Remember, the best performers of all S&P 500 sectors during the mid-cycle expansion/recovery phase tend to be the Technology sector. Specific Technology industries such as semiconductors, electronics, and hardware typically begin to pick up considerable momentum as the economy shows signs of a sustainable turn. The Communication Services also attract investment interests during the mid-cycle phase due primarily to the economically sensitive media sub-industry and the technology-driven names.
Are investors buying into the mid-cycle expansion/recovery to the business cycle as well when NBER has yet to call an official end to the February 2020 recession?