By James T. Tierney, Jr.
US stocks have been volatile recently as investors try to decipher the Fed. But chasing monetary policy winds isn't a good investing strategy. Recent market trends indicate that company fundamentals are a better guide to equity returns.
Investors in US equity markets are experiencing big mood swings. The S&P 500 (NYSEARCA:SPY) fell by 2.5% on Friday, September 9, amid concerns that the Fed might soon raise interest rates. On the following Monday, the market recouped most of its losses on fresh signals that the Fed might take its time. Volatility continued through the rest of the week.
Amid the commotion, the second-quarter earnings season, which ended just a few days earlier, was left in the dust. Yet, we believe recent earnings and trading trends provide some important signposts for equity investors preparing for third-quarter earnings in just a few weeks.
Lower US Stock Correlations
During the summer, as companies posted second-quarter earnings reports, US stock correlations dropped sharply (Display). Earlier in the year, stocks generally traded in the same direction, with less regard to their underlying fundamentals. By the end of August, stock correlations had fallen into the lowest 25% of all readings since 1984, when the data set begins.
Higher correlations typically indicate that stocks are being driven by broad macroeconomic or market concerns. In other words, investors aren't really distinguishing between companies based on their fundamental strengths and weaknesses. Lower correlations are good news for active managers, who depend on the market rewarding companies with stronger earnings growth in order to generate excess returns.
As stock correlations fall, we're seeing evidence that fundamental performance is becoming more important, even for companies in the same lines of business. Take Wal-Mart and Target as examples. Wal-Mart delivered second-quarter same-store sales growth of 1.6% and provided an upbeat forecast for sales and earnings in the second half. Target's second-quarter comparable sales fell by 1.1%, and the company expects weak sales for the rest of the year and has cut its earnings guidance. And the shares? Wal-Mart stock has surged by 19% in the year to date through September 13, while Target has dropped by 3% over the same period.
Another pair that has significantly decoupled is Yum! Brands (NYSE:YUM) and Starbucks (NASDAQ:SBUX). As analysts revised their 2016 earnings estimates for Yum! Brands up by more than 3%, the stock's price/earnings (P/E) ratio expanded from 21 times at the beginning of the year to 24 times on the improving fundamental outlook. In contrast, Starbucks has seen flat earnings estimates for 2016, modest decreases for 2017 and a P/E contraction from 30 times at the beginning of the year to 28 times today. The net result: shares of Yum! Brands have rallied by 21%, while Starbucks stock has declined by 9% (through September 13).
Preparing for 3Q
Making distinctions between companies like these will be essential in the third quarter. The environment for earnings remains tricky, as 78 companies in the S&P 500 have issued negative earnings guidance for the third quarter, while only 35 have issued positive guidance, according to FactSet data.
While correlations are breaking down, there are still imbalances and distortions in some companies and sectors. These trends present opportunities - and risks. For example, sectors such as telecom, utilities and consumer staples have posted lower-than-expected revenue growth, yet their share prices have rallied (Display) as investors have sought safety in high dividend yield stocks. These sectors have also missed earnings estimates more than others. With a lack of fundamental support from revenues and earnings, we think these crowded trades are looking increasingly risky.
Conversely, consider the healthcare sector. Medical companies have consistently beaten expectations on revenue growth, yet shares have underperformed because of political controversy around the sector. We believe healthcare companies with strong business dynamics and little exposure to political uncertainties - such as drug price controls or a pullback from Obamacare - can be found at attractive valuations today.
Stock-picking Skill vs. Rate Speculation
Of course, nobody can guarantee that correlations will stay at the current level. However, history suggests that the correlations seen over much of the last 18 months were abnormally high. So, if correlations stay low or even revert to normal levels for a sustained period, we believe companies with strong fundamentals will be increasingly rewarded.
This will create a great environment for portfolios with high active share and selective holdings to demonstrate the benefits of stock-picking skill. While it's always hard work to identify stocks that can deliver, we believe that stockpicking based on differentiated research insights can be more rewarding for long-term performance than trying to discern the intentions of the Fed.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.