In my last article, I described how labor markets were driving consumer spending and manufacturing, and how labor markets would drive corporate earnings and lead the S&P 500 (SPY) to new highs in 2019. In this article, I look into the market sector by sector to uncover the three top sectors for investment in 2019.
Earnings Are Robust, And Growing, Just Not As Fast As Before
2018 has been a spectacular year for earnings growth; the economy was booming, tax-reform kicked in, and many sectors saw robust double-digit growth in earnings.
Like all good things the earnings growth boom came to an end in the last quarter and set the stage for the November/December 2018 equity market correction that has stocks trading at their lowest values in years.
The November/December correction was caused by several factors that all boil down to one thing; slowing earnings growth.
The broad market, up until November, had been rising on the euphoria of three things; earnings growth, earnings growth acceleration, and rising estimates for both. The trifecta of good news inflated the market on the expectation that double-digit growth would continue and, well, you know the rest. Earnings growth outlook began to fall, earnings growth began to decelerate, and market valuations deflated with them.
What traders and investors need to keep in mind is that “peak earnings”, as it was called, was not the peak of earnings growth, it was the peak of the acceleration of earnings growth. Earnings are still growing in 2019 and will continue to grow, it will just be at a slower pace than the previous year.
The Trump Tax Plan; Earnings Growth Has Slowed But At Elevated Levels
The Trump tax plan gave earnings growth a serious boost when it was passed and that is clearly seen in the chart below. This chart tracks quarterly consensus earnings growth estimates, as reported by Factset Insight, on a week-to-week basis, up to and through the end of each respective earnings cycle. The effect of the tax-cut on earnings growth has worn off but don’t discount the impact of tax reform, businesses are still earnings far more today than they would have before the tax plan was passed.
The good news, the great news, is that the market correction brought equity valuations to their lowest levels relative to forward-earnings in nearly a decade. That fact, along with the expectations that earnings growth will continue, is a good reason to get back into the market. From what I’ve been seeing in the S&P 500 over the first two trading week’s of 2019 others agree with me; money is flowing back into the market.
Earnings Growth Outlook For The Broad Market
The S&P 500 will most likely post a final annual earnings growth rate above 21% by the end of the 2018 reporting cycle. This will be the strongest year for earnings growth in a decade and fueled by the Trump economy, not just the Trump tax plan. Growth is going to slow next year, down to 7.3%, but that’s not the end of the story. Earnings growth continues, is expected to re-accelerate by the end of this year, and accelerate again in 2020.
Looking at growth on a quarterly basis, the slowdown in earnings growth will bottom in the first quarter of 2019 and then slowly re-accelerate into the end of the year. By the fourth quarter earnings growth is expected to surge again which fulfills two of the three most important conditions of a high-quality earnings-driven rally; positive earnings and earnings growth acceleration.
The estimates for next year are still falling and that will weigh on equity prices in the near-term. While a concern there are several reasons to believe economic activity and earnings growth will begin to pick up again this year, the two primary are trade and the Fed.
On the trade front, there is growing optimism the US/China trade war will soon come to an end and that will boost global economic activity, not just that of China and the US. The globe is an inter-linked economy whether we like it or not, improved relations between the world’s two largest economies will be felt universally.
On the Fed front, the FOMC and Jerome Powell have made it abundantly clear they are patient, flexible, watching and waiting to act if needed, or not, which seems to the case right now.
A less hawkish Fed and a slower trajectory of interest rate hikes is one less headwind for US economic activity. Once these events begin to affect the earnings outlook we can expect to see earnings estimates begin to rise and when that happens market momentum will accelerate as well.
Lowball Estimates Set The Market Up To Beat Consensus
Now, regarding outlook and the earnings estimates. The analysts are notoriously wrong. Not really wrong, but wrong enough (because they are playing it safe, low-balling estimates) to produce a trend of bottom-line beats within the S&P 500 that has been in place for more than three years.
The average S&P 500 has beaten its consensus earnings estimate by 5% over the past year and 4% over the past five, and that is not expected to end. In fact, with all the negativity in the market, estimates have been falling harder than usual as the 4th quarter earnings cycle approaches.
This trend is setting the market up to not only beat consensus but to beat the consensus by a larger than expected amount and that will help support equity prices over the short and long-term.
The Three Sectors You Need To Own In 2019
Earnings and earnings growth are a strong driver of the market. While strong growth in the current reporting cycle will drive the price of stocks higher, it is the expectation of future growth that will keep them higher. Looking to the fourth quarter 2018 reporting cycle the top sectors for growth are not necessarily the top sectors for 2019, but there is some overlap.
The energy sector is #1 for earnings growth in 2018 and the 4th quarter but, since the implosion of oil prices, it’s dominance as an earnings leader has come to an end. Looking to 2019 expectations the energy sector is only expected to post the 6th strongest earnings growth which is not enough, in my opinion, to warrant new investments. To put this into perspective the energy sector will see earnings growth top 105% for 2018 but fall to a mere 6.5% (or lower) in 2019.
The number #2 and #3 sectors, industrials (INDU) and financials, are a different story. The Industrials are in #2 spot regarding earnings growth for the 4th quarter and all of 2018 but move up to #1 for 2019 making it the leading sector for investment in the New Year.
The industrial sector has had the highest rate of companies reporting revenue and earnings above estimates over the past few quarters. This fact, along with the expectation 8 of 12 industries are expected to post double-digit earnings growth, will help drive this sector to new highs in 2019. The construction & engineering sub-sector is looking at +50% earnings growth, trading companies +39% earnings growth and road & rail will see earnings grow more than 30%.
The Industrial Sector SPDR XLI (XLI) should see prices retest the December highs before mid-year and move on to retest the all-time highs before the end of the year. Over the next week look out for earnings from transport powerhouse CSX (CSX) and Alcoa (AA).
The financials, currently #3 for the fourth quarter and all of 2018, will hold on to that position for 2019 making it the third-best sector for investment from the earnings growth perspective. The fourth-cycle may show some weakness in trading-related revenues but deposits, loan growth, and consumer activity will be strong. Any weakness in stock prices should be viewed as an attractive entry point for long-term investment but that may not happen because this sector has seen the largest decrease in estimates of any sector as we approach peak earnings season.
The Financial Sector SPDR XLF (XLF) is forming a Vee bottom and poised to break out to new highs. This break-out may be sparked by earnings from Wells Fargo (WFC), JP Morgan (JPM), Citigroup (C), BB&T (BBT), and American Express (AXP) which are all due to release earnings over the next week.
The consumer discretionary sector, #5 for the fourth quarter and all of 2018, will see a significant improvement in its standing relative to earnings growth strength. This sector, driven by steady, long-term improvement in the labor market and earnings conditions, will move up three places to #2 in 2019. With wages growing above 3.0%, more Americans working than at any time in history, a shortage of workers driving wages and incentives higher, the consumer will be stronger than ever before. In terms of revenue and the consensus; the discretionary sector has been beating consensus by the largest rate of any of the 11 S&P 500 sectors.
Of my three picks, the chart of the Consumer Discretionary SPDR XLY (XLY) looks the most bullish. The ETF has broken above the short-term 30-day moving average, is supported by strong momentum and upwardly trending stochastic, and poised to retest the December highs well before the middle of the year. There are no significant discretionary stocks reporting in the next week but we are expecting a report from consumer tech-giant Netflix (NFLX) which is affected by consumer sentiment.
The Bull Market Is Still Here, Earnings Will Lead The Way Higher
Earnings are by far the most powerful driver of equity market valuation. While a slow-down of growth has caused a major market correction that correction has put equities at their lowest values in nearly a decade. That fact, along with an expectation for earnings growth, earnings growth acceleration, low-ball earnings estimates, and catalysts for an economic reacceleration in 2019, is going to drive stocks higher over the next quarter and into the end of the year.
The top three sectors you should be invested in to capture that growth are the industrials, the consumer discretionary, and the financials. These sectors have a high expectation for growth, a history of outperforming expectations, are supported by economic trends within the US, and have a lot to gain from improved US/China trade relations and easing outlook for future interest rate hikes.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in xli, XLY, XLF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.