Rotation Into Defensives May Begin In Earnest Now

by: Caleb Sevian

According to Reuters, 59% of S&P 500 companies have now reported earnings with 74% beating their numbers, 15% missing and 11% reporting in-line. This compares favorably to average quarters where about 60% companies exceed estimates.

Impressive expansion, but not as impressive at the estimated 15% year over year gain that these companies have shown for growth. Diligent analysis can easily lead to questions about the magnitude of this number because stock buybacks have skewed the numbers this year, making it more complicated to discern earnings growth from reductions in shares outstanding. But with corporate balance sheets still showing record levels of cash there looks to be no end in sight for massive stock buy back programs continuing to be a driving factor in year over year EPS growth.

GDP continued its 2006 trend from 5.6% in Q1 to 2.6% in Q2 to the dismal 1.6% Q3 reported on Friday. The most fascinating part of the report had to do with the break down of its components. With the median new home price down nearly 10% in the last 12 months the expectation was that residential investment would be lower, but the 17.4% declined it posted shocked even the bears. The American consumer, as usual, was not phased. In fact, the University of Michigan Consumer Confidence poll reported the 8th largest gain in its history in October. The GDP component of consumer spending supported this statistic by posting a 3.1% rise while personal savings continued at a negative rate. The net take away from this is that it would seem that the only thing that American consumers are concerned about spending money on right now is homes, everything else is pretty much fair game.

The New York Times reported that Dean Baker of the Center for Economic Policy and Research estimated that Americans have been extracting in the form of cash out equity financing as much as 700 billion dollars a year. The looming question is, with unemployment sure to rise over the next year and home prices likely to decline, where will the ever persistent American consumer find the extra capital to continue their spending spree?

I have been commenting for the last couple months about the perplexing nature of the rally we have been undergoing, lead by high beta and consumer discretionary stocks, neither of which normally lead us into an economic downturn and both of which are up nearly 20% since mid July according to an article published in Business Week last week. Typically, we would see defensive sectors such as pharmaceuticals, staples and utilities as havens for capital in an economic downturn.

Last week we may have begun see the tides turn with defensives posting sharp gains and it is likely after the quarterly rebalances by the big mutual funds we will begin to see the rotation take full effect. The other surprise performer of Q4 may be energy after its performance as the red headed stepchild of Q3.