Wednesday evening marked the unofficial kick-off to earnings season, as Alcoa (NYSE:AA) reported its second-quarter results. While the aluminum producer gave the season a positive send-off (or "less negative," if we're frank), I'm not sure investors will find much cause for celebration as the results come in.

According to an estimate from Standard & Poor's, as reported earnings for the S&P 500 for the second quarter will fall by half year on year, so expectations are already set pretty low. Even so, the market has been grasping at "green straws" of positive economic data, going on a 30.5% run since the March 9 low. Optimism appears to have run its course for now as investors wait for hard earnings data to validate their hopes.

Where does the market stand right now?
Unfortunately, I think these green straws will prove to be either a statistical mirage or a bounce along the path of what will otherwise be a very weak and protracted recovery. If this is the case, how exposed are investors? Let's look at the market's valuation for a clue.

At yesterday's close of 879.56, the S&P 500 is trading just over 15 times average inflation-adjusted earnings for the past ten years. By historical standards, that is slightly cheap -- the average going back to 1881 is 16.3.

However, bear in mind that we are entering a period in which normal growth in the economy is below the historical trend, as the American consumer scales back on purchases in order to repair his/her balance sheet. This will have a knock-on effect, lowering corporate profit growth, which justifies a lower multiple. With that said, I think we should consider that the market is no better than fairly valued. Owning stocks right now isn't a problem -- if one can adopt the appropriate time horizon (7-10 years, no less).

Are there pockets of opportunity and/ or safety?
The two sectors that exhibit the greatest earnings uncertainty, measured by the ratio between the high EPS estimate and the low EPS estimate for 2009 are far and away financials (429%) and materials (312%), followed by energy (179%) and consumer discretionary (184%) in a virtual tie for third place.

All other things equal, earnings uncertainty creates opportunity for investors that have a longer time horizon than most institutional investors (6-12 months). However, patient capital is ineffective unless it is driven by value. In that respect, energy and financials look more attractive than materials and consumer discretionary (as the following table shows).

Energy and financials may not be undervalued as a whole, but they look like rich hunting grounds for experienced stock pickers -- investors with the time and ability to analyze individual names.

(I realize that consumer discretionary is actually cheaper on the basis of its P/E than financials -- I'll come back to why I'm not giving the nod to the former later on.)

 

2009e EPS*

P/E

Return Since March 9th Market Low

S&P 500

$57.53

15.3

30.5%

Energy

$22.64

15.5

13.1%

Materials

$ 4.74

30.9

34.7%

Industrials

$13.46

13.4

35.8%

Consumer Discretionary

$ 8.82

19.8

38.6%

Consumer Staples

$17.32

13.8

19.4%

Health Care

$26.13

11.5

18.4%

Financials

$ 7.35

20.6

80.6%

Information Technology

$15.70

17.6

38.5%

Telecoms Services

$7.55

13.0

11.2%

Utilities

$11.71

11.7

20.8%

*This is a bottom-up estimate derived from the estimates for the index components.
Sources: Index values, Author's calculations, based on data from Capital IQ and Standard & Poor's.

If you're looking for some specific names, I ran a screen for "safe" stocks in these sectors, inverting the criteria of GMO strategist James Montier’s screen for stocks that could cause permanent losses. The resulting stocks are priced at less than 16 times cyclically-adjusted earnings and don't appear to exhibit significant bankruptcy or earnings risk. Here are three of the names that came up:

Company

P/E (2009e earnings)

Cyclically-Adjusted P/E Ratio*

National Oilwell Varco (NYSE:NOV)

8.6

8.3

Moody's

17.3

11.0

ConocoPhillips (NYSE:COP)

11.9

8.9

*Price divided by average earnings-per-share over the prior 10 years. Note that this P/E differs from the one cited for the S&P 500 below; the latter uses inflation-adjusted earnings.

Lower-risk sectors
At the other end of the spectrum in terms of earnings uncertainty, are consumer staples and health care. These sectors also look appealing right now, particularly for investors with less appetite for risk. They are defensive sectors, of course -- but that's not all.

Consumer staples and health care were left behind by most sectors in the stock market rally from the March 9 low (see table above). That trend looks set to reverse, as they appear reasonably priced; I expect investors to warm to them as the market comes to terms with an anemic economy recovery (I don't think such a recovery has been fully factored into stock prices yet).

The following table contains four names that were produced by the same screen I referred to earlier and may be worth further scrutiny:

Company

P/E (2009e earnings)

Cyclically-Adjusted P/E Ratio*

Wal-Mart Stores (NYSE:WMT)

13.6

15.3

Walgreen (NYSE:WAG)

14.1

14.2

Zimmer Holdings (NYSE:ZMH)

10.2

11.3

Bristol-Myers Squibb (NYSE:BMY)

10.2

13.9

*Price divided by average earnings-per-share over the prior 10 years. Note that this P/E differs from the one cited for the S&P 500 below in that it is based on nominal earnings, while the latter uses inflation-adjusted earnings.

And one sector worth avoiding
Now that I've highlighted four sectors that I think are relatively attractive, I'll leave you with a warning regarding one that I find distinctly unattractive: consumer discretionary. At nearly 20 times estimated 2009 earnings, it looks pricey at a time when discretionary item purchases are much harder for consumers to justify (to themselves and/or their bankers). As investors come to terms with an economic environment that is permanently different ("permanently" insofar as stock valuations are concerned, in any case) than the one they have known until recently, that valuation may not hold up. Happy hunting!

Looking for even more stock names? Morgan Housel identifies three high-quality companies that are still cheap.

More Foolishness:

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Alex Dumortier, CFA has no beneficial interest in in any of the companies mentioned in this article. National Oilwell Varco is a Motley Fool Stock Advisor selection. Wal-Mart Stores is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.