Performance drivers: Focus shifts during earnings season

The past 12 months have been spectacular for the stock market. There has been a tremendous rise in equity prices as reflected by the Dow 30 returning 14.74 per cent while the S&P 500 returned 16.7 per cent on a rolling 12-month basis. The stock market was getting close to reaching a five-year high in September 2012. However, as of mid-October, the stock market has started to see a setback as investors are shifting their focus back to one of the main drivers of stock market performance; corporate earnings.  

The spur in the stock market over the past couple years has been primarily due to round-upon-round of quantitative easing, which has been advantageous for owners of stocks. It has pushed investors out of bonds by creating historically unattractive yields for fixed income (eg 10-Year Treasury yields at 1.66 per cent) with no other place to go but equities. It has also helped corporate balance sheets become stronger by helping companies improve their bottom line. This has been done through the company income statements by creating ultra-cheap financing for corporations.  

For example, in January of 2012, Warren Buffett’s Berkshire Hathaway was able to issue $750 million in five-year bonds with an attached interest rate of 1.6 per cent. In addition they issued another 10-year bond for $250 million with an attached interest rate of 3 per cent.  

This replaced financing that the corporation was paying a weighted average borrowing rate of around 6 per cent previously. That means a cost savings on interest expense for this series of debt in excess of 50 per cent.  

In the latest round of quantitative easing which was announced on 13 September, 2012, the Federal Reserve gave no specific end date or a specific total amount of money that will be committed to help spur the economy.  

The call was for an open-ended amount of money to be spent for a prolonged period of time until the unemployment rate has reached more of a desired level. According to some economists the target unemployment rate is around 5.5 per cent.  

Most companies have refinanced a substantial amount of their debt over the past five years and the reduced interest rate outlook over the next three years will most likely help repair their balance sheets further. However, this only deals with the expense side of the income statement.  

Investors know that the expense side is looking much better for most corporations, but equity prices are becoming pricier without larger increases in the revenue side of the income statement. Therefore, investors are going back to basics and focusing on the drivers of corporate earnings.  

 

What to look out for 

Most companies will be reporting their third quarter performance over the months of October and November. Aside from reviewing the financial performance of the stocks you own, it is recommended to also follow the performance of stocks in certain industries.  

While we are still in the early phase of the economic recovery, it is best to focus on reviewing the performance of stocks within certain sectors and industries.  

Some industries may give you a better glimpse of what is going on in the economy overall.  

Whereas other companies and industries may not be giving very good insight to how the economy is recovering as a whole.  

 

Sectors to watch and why 

Most portfolio managers tend to watch how financial companies perform. Typically they benefit from a backdrop of low interest rates. Increased mergers, acquisitions, and underwriting is a sign of greater economic expansion and reflects signs of economic improvement which tends to lead the market’s advance.  

Consumer discretionary sector companies also show improvements in their income statement when the economy is starting to expand.  

It is also a good indicator of market sentiment. As individuals feel more comfortable they tend to purchase more discretionary items such as jewellery, handbags, watches and more expensive items such as cars and houses. Cars and houses are very large purchases that individuals need to feel very comfortable with their personal finances to make and can be a great sign that the economic recovery is here to stay.  

The industrials sector includes some industries, such as air freight, trucking and rail transportation, where demand escalates rapidly in the very early stages of recovery, with the best performance typically coming during the several months after the economy emerges from recession. 

 

Sectors to watch next 

Next year it would be wise to also start to monitor industries and companies that tend to do better further in the economic cycle. The peak in demand for their products or services tends to not be as great until the expansion has become more firmly well-established. These sectors typically would be energy, materials and certain industrials.  

Some industrials, such as heavy equipment and engineering and construction services, tends to pick up during this phase because it takes some time for companies to feel confident and profitable enough to initiate spending on large-scale infrastructure projects. Likewise, such longer-term projects also create more demand for energy commodities and other raw materials, such as copper, aluminium and steel. 

 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. 

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