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The cautiously anticipated earnings season got into full swing on Monday, July 9th; the next few weeks will confirm how much the synchronized global slowdown is affecting U.S. companies. Leading up to second quarter results, on a sector basis, the market continued to feature risk-on leadership; the best-performing sectors were Technology, Consumer Discretionary and Financials. Although consumers were wrestling with high unemployment, depressed home values and tight credit, they continued to spend during the first quarter and into the second. During the second quarter, a rotation in sector leadership occurred; best-performance came from Utilities, Consumer Staples and Healthcare. In other words, markets were suggesting caution long before the pundits. For actively managed portfolios and those that wish to exploit opportunities within undervalued sectors, now is a good time to re-evaluate which areas of the market have the greatest upside potential.

Identifying sectors that warrant overweighting requires more than simply looking at the most recent winners which would be more consistent with a "sector rotation strategy". Instead, we incorporate factors such as earnings growth and revisions, valuations, performance, yield and economic sensitivity. One of the most widely used measures performance is price to earnings or P/E ratios. To determine the P/E's for this study, we used recent prices against forecasted earnings per share for 2012. We then averaged growth rates for three years beginning with 2011; we prefer growth rates above current price to earnings. Price divided Earnings divided by Growth creates a time honored formula known as PEG. In our opinion, a PEG ratio below 1.0 generally implies value and upside opportunity while ratios above 2.0 would be cause for further examination.

We have applied our modeling to all 10 sectors and the market to conclude an ideal allocation strategy. The sectors with the lowest PEG ratio include Technology, Energy and Materials, all below 1.0. The sectors with the highest include Utilities, Telecom and Staples, all above 2.0. Telecom and Utilities raise particular concern given PEG ratios near 4.0. However, these two sectors are instrumental in most income or dividend style portfolios. Even so, that doesn't mean they are immune to significant pullbacks. Conversely, a low PEG is not a sure fire winner. For example, although Energy scores well on PEG valuation (currently around .60), earnings revisions are negative. Therefore, looking at future earnings potential, PEG will begin to rise as profits remain under pressure.

At this point, other factors come into play, including earnings revisions, historical market weights, dividend yields and economic sensitivity and technical analysis. At present, our Over-Weight rankings include Technology, Basic Materials, Healthcare and some Financials. We are underweight Energy for reasons mentioned earlier. Consumer Staples, Telecom and Utilities have lead the way most recently as investors seek the safety of these dividend payers. Stocks in these three sectors have flourished along the way thus pushing the dividend yield ever lower. For those who are overweight in these sectors, now is good time to reconsider diversification and downside risk. If you are investing strictly for income and don't mind the volatility, long in the tooth sectors such as Consumer Staples at least provide some reason for staying invested; dividends.

Looking at our technical analysis, we have seen a number of upgrades with many signs pointing to a more bullish outlook. However, I am concerned that this may be short-lived. Economic data has been below expectations for several months and the latest jobs report provided no exception. Being the primary metric for the Fed, expectations for more easing will increase following the fourth straight disappointing report. Looking at the charts, the S&P 500 has moved higher, since early June, indicating a new bullish trend as it forms a rising wedge. Opposing the optimism, I believe the recent mini-rally comes within a bigger downtrend. The 10-year treasury failed to break above the 1.7% yield; this persistent pattern translates to a slowing economy and lower stock prices. The euro currency continues to trend lower with the next support around 118. Turning to one of our favorite indicators, the S&P 500 50 day moving average, we consider the medium term as bearish. Roughly 50 percent of the stocks in the S&P 500 are trading above their 50-day moving average; that is not enough to reverse the negative trend. On May 21st, the percentage of the S&P 500 above the 50-day moving average plunged into bear market territory with a move below 15%. This was the fourth bearish signal in the last five years. With the June advance, our indicator moved above 60% (has since moved below 60%) but remains well short of the 85% threshold required for a trend reversal or bullish signal.

The Bottom Line: A synchronized global slowdown is upon us, and short of having needs that require you stay fully invested, moving to the sidelines - with at least some of your assets - could prove to be a good strategy. The markets typically line up strongly heading into a presidential election; thus providing, perhaps, the only impetus needed to reach the expected 14% earnings growth on the S&P 500. Maybe I am missing something, but that number seems brazenly optimistic. For the near term, we have reduced our equity exposure another 5%; our core cash is approximately 35% on average. We are constantly seeking opportunities in this volatile environment and continue finding value in corporate bonds, high yielding stocks and some foreign bonds.

Some analysts contend that the market has already priced in the disappointment of a poor earnings season but I vehemently disagree. The downside risk is more complicated than earnings alone. Europe has yet to reach an agreement on a tenable plan of action. Washington remains obstinate and refuses to address critical issues that only make matters worse. Unemployment remains at elevated levels and consumer sentiment has fallen from 79 to 72; a significant decrease since May of this year. We anticipate more consolidation with a bias toward selling pressure which, in our opinion, makes this a time to invest with caution while protecting gains and holding cash for opportunities created by declining stock prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Earnings Season, Sector Rotation And Global Slowing; Sidelines May Be A Good Bet