The Best and Worst Sectors: Earnings Season Preview

I recently argued that the near-peak profit margins of U.S. companies would fall over the next several quarters, resulting in negative earnings surprises and putting pressure on stock prices. It's possible this process began in the second quarter, during which sentiment soured, unemployment remained stubbornly high, and the recovery in housing flagged. In that context, which sectors are well-protected and which are vulnerable?

Think defensively
I've made no secret about favoring defensive sectors in this environment, and health care and consumer staples provide some buffers going into this earnings season. Their second-quarter earnings estimates have already begun to come down since the end of March and health care is the cheapest sector in the S&P 500 (11.3 times its 2010 earnings per share estimate).

The Consumer Staples Select SPDR ETF (NYSE: XLP  ) and the Healthcare Select SPDR ETF (NYSE: XLV  ) track these S&P 500 sectors. Both of them look likely to outperform the SPDR S&P 500 ETF (NYSE: SPY  ) over the next 12-18 months. (For three individual stocks in these sectors that look attractive, see "3 Stocks and 3 ETFs to Salvage 2010.")

Cyclical is suspect
On the other hand, industrials and financials look particularly vulnerable to disappointments because they're cyclical and they're two of the three sectors that have experienced the highest increase in their second-quarter EPS estimates since the end of March. Worse, for industrials, it's the most expensive sector on the basis of its price-to-earnings multiple (14.8 times its 2010 EPS estimate against 13.1 for the S&P 500).

3 bellwethers
Less than 5% of the S&P 500 will report earnings next week, but that number includes cyclical bellwethers Bank of America (NYSE: BAC  ) , Intel, and General Electric (NYSE: GE  ) . GE has significant industrial and financial businesses, yet its earnings estimates have not budged in at least 60 days. Meanwhile, Bank of America's have declined over the past 30 days and the past seven days (the same is true of another Dow financial, JPMorgan Chase (NYSE: JPM  ) ). If GE meets or exceeds those estimates -- for the right reasons (watch the top line) -- it could indicate that economic activity is holding up better than expected.

If you're concerned about the impact of slowing growth and ballooning government debt on U.S. stocks, there are alternatives for your money. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On July 09, 2010, at 5:42 PM, RobMonaco wrote:

    Good article Alex, thanks!

    This is a little bit of topic but I find it amazing:

    http://www.ft.com/cms/s/0/b0877070-8b84-11df-ab4d-00144feab4...

    'Some of the world’s biggest fund managers are now holding up to 40 per cent of cash in their portfolios. Before the financial crisis, they held as little as 5 per cent.'

    Im 32 years old and don't have a job but I have 10.5M euro (60% bonds/35% stocks and 5% cash). I wonder if I'm 'foolish' and taking to much risk with so little cash...

    Would love to get your opinions!

  • Report this Comment On July 09, 2010, at 7:52 PM, yodesai wrote:

    Alex,

    Whilst I agree with your insightful article after the first sentence, I also believe the sentence is misleading and appearing to claim false credit. Yes the market and share prices have peaked and we have seen a significant decline and congratulations on calling it right, however it is not due to profit margins or indeed the general performance of US companies declining - on the contrary they are improving. The drop I would proffer is due to the rest of your article and a somewhat irrational market reaction to actual market data (nothing new here) and of course the ultra cautious hedging by the hedge funds (pun totally intended).

    I have long been a follower of Motely Fool due mainly to its honest and "common man" approach. There is nothing I hate more than any number of analysts / experts telling us exactly why things went wrong and how they predicted it - please do me a favour, if this was true why are they not riding off into the blue yonder?

    I would just like analysts to give the total true picture, and how we can learn from it - as I say I believe MF has been the closest to it - so please don't change. Perhaps I am being too naive, analysts like politicians have after all a living to make and the positive spin is king!

    Nothing personal, just a general rant 

  • Report this Comment On July 09, 2010, at 11:38 PM, TMFAleph1 wrote:

    yodesai,

    Thanks for your comments. I don't make any claim to have predicted the market decline that has occurred since the end of April. The article I refer to was published at the beginning of this week and concerns what I think will occur over the next few quarters -- we don't yet know whether what I wrote is correct or not.

    When I wrote: "It's possible that this process began in the second quarter", I should have been more precise: I am speaking here only of the first part of that process, i.e. a decline in profit margins and not any effect on stock prices. We don't yet know whether margins did, in fact, decline in the second quarter. In any event, I only said this was possible; it is also possible that margins continued to expand during the second quarter. However, I have a pretty strong degree of conviction that margins will decline over the next several quarters.

    I agree that there are lot of 'false prophets' in the financial services industries. Personally, I try not to make predictions in areas in which I am not competent or in areas in which I know that all predictions are useless.

    Best,

    Alex D

  • Report this Comment On July 09, 2010, at 11:43 PM, TMFAleph1 wrote:

    @RobMonaco,

    I'm afraid I am forbidden from giving any kind of individual advice in this forum. If you wish to contact me privately, you may do so at alex.dumortier@gmail.com

    Best,

    Alex D

  • Report this Comment On July 11, 2010, at 1:07 PM, MegaEurope wrote:

    "[H]ealth care is the cheapest sector in the S&P 500 (11.3 times its 2010 earnings per share estimate"

    Insurance and reinsurance are cheaper on forward earnings.

    http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/...

  • Report this Comment On July 11, 2010, at 4:35 PM, TMFAleph1 wrote:

    @MegaEurope,

    Thanks for pointing this out. As you drill down within sectors, you do come across industries that are cheaper than the Health care sector.

    Best,

    Alex D

  • Report this Comment On July 16, 2010, at 5:10 PM, weihou258 wrote:

    google "Mutual Fund Cash Levels", It is scary. here is one.

    http://home.comcast.net/~royashworth/Mutual_Fund_Cash_Levels...

    If rich people has 5% in cash, should not expect the poor will put 95% money in stock market too.

  • Report this Comment On July 17, 2010, at 3:31 PM, Saintramus wrote:

    Isn't the idea to counterintuitively buy cyclical stocks, e.g. industrials, when their PE is high and sell when it's low?

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