Sector perspectives: profitability problems

As markets sit near all-time highs, remember to keep an eye on earnings, says our sector strategist.

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As the second-quarter earnings season wraps up, earnings for S&P 500® companies declined 3.2%* compared to the same quarter last year, marking the fifth consecutive quarter of lower earnings, according to FactSet. Looking forward to the third quarter, analysts expect S&P 500 earnings to shrink again, with an average estimate of –2.1%.

The largest contributor to negative growth is the energy sector once again, while consumer discretionary and health care stocks are expected to post the best growth.

What might this mean for investors? In this Viewpoints interview, Denise Chisholm, sector strategist, explores a key theme that may be worth watching this year—profitability problems—and how using defensive sectors may help manage a portfolio in this investing climate. As always, before making investment decisions, you should do your own research and base your investment strategy on your time horizon, financial circumstances, emotional tolerance for portfolio volatility, and financial goals.

What do profit recessions mean for the economy and markets?

Chisholm: Earnings have been declining on a year-over-year basis. Historically, most earnings contractions have been tied to increased volatility, and typically a defensive sector rotation.

But earnings contractions are not always associated with economic contractions. Historically, about half of these earnings contractions are associated with recessions. Some notable examples of non-recessionary earnings contractions occurred in 1966, 1986, 1993, and 1998. Now, this might make you feel better about the economy. However, we should take note that three of these four non-recessionary earnings contractions occurred within a range of some fairly sizable bear markets.

How are profit contractions related to defensive sector rotations?

Chisholm: Most profit contractions are associated with a defensive sector rotation—when defensive sectors like consumer staples, health care, telecom, and utilities have often outperformed. The key is relative earnings. Stable earnings in defensive sectors may prove attractive if earnings are declining in other parts of the market. While the past is no guarantee of future results, in times of profit contraction we have seen a portfolio of defensive sectors outperform.

Since 1966, the average earnings contraction has been 17 months, significantly longer than the current pullback, and defensive sectors have outperformed cyclicals by an average of 26 percentage points during that time, compared with 8 percentage points in the current earnings contraction.

Historical profit contractions
  Duration
(In Months)
Average Defensive
Relative Performance
Average Cyclical
Relative Performance
Average Performance Difference
(Defensive - Cyclicals)
1966 19 11% –1% 12%
1970 26 18% –11% 29%
1975 10 6% –10% 16%
1981 9 17% –7% 24%
1982 15 4% –4% 8%
1986 12 19% –11% 30%
1990 27 35% –18% 53%
1998 18 17% –10% 27%
2001 12 10% –6% 16%
2008 25 29% –17% 46%
2001 12 10% –6% 16%
2008 25 29% –17% 46%
2015-16 9 6% –2% 8%
Average earnings contraction
(1966-2008)
17.3 16.6% –9.5% 26.1%
2015/2016 contraction -
relative to average
52% 36% 21% 31%
Avg. Non-Recession 16.3 15.7% –7.3% 23%
Avg. Recession 17.7 17.0% –10.4% 27.4%
For illustration only. Past performance is not a guarantee of future results. Results are based on the performance during profit contractions, which were defined to start when the median year-over-year trailing 12-month earnings growth for the largest 3,000 U.S. stocks goes below zero. The period ends when the median year-over year earnings growth goes positive again. The defensive sectors are staples, utilities, health care, and telecom. The other six sectors were considered cyclical sectors. The 3,000 stocks were sorted into sectors based on the GICS. The stock universe was refreshed each month. Relative performance compares a simple average of the defensive and cyclical sectors to the average for the full universe of 3,000 stocks. The delta shows the difference between cyclicals and defensive sectors. The average performance was calculated as a simple average of the price change for each sector for each earnings contraction. The percent of average shows how the performance during the current profit contraction, beginning in March of 2015 through May 1, 2016, compares to the historical average from the downturns since 1966. Source: FMRCo as of May 30, 2016.

Are profitability problems over? Or are they just beginning?

Chisholm: Current earnings growth estimates seem aggressive to me. Unless a rebound in global growth becomes evident soon, not only are we unlikely to see earnings for next year achieve expectations, it becomes possible that the profit contraction could continue. If you believe that these profitability problems could continue, a portfolio tilted toward the defensive sectors may be a way to diversify your portfolio and take advantage of this sector rotation theme.

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Diversification does not ensure a profit or guarantee against loss.
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