Is This The Rally You’ve Been Waiting For?

Is This The Rally You’ve Been Waiting For?
Carl Hazeley

over 1 year ago3 mins

  • Analysts have cut their second-quarter earnings forecasts for S&P 500 companies by 1.3% in the past two months – a smaller-than-average trim.

  • They've also increased their earnings forecasts for the second half of 2022 and for 2023.

  • The stage is set for US stocks to rally – and shares that have momentum and quality on their side may be poised to do particularly well.

Analysts have cut their second-quarter earnings forecasts for S&P 500 companies by 1.3% in the past two months – a smaller-than-average trim.

They've also increased their earnings forecasts for the second half of 2022 and for 2023.

The stage is set for US stocks to rally – and shares that have momentum and quality on their side may be poised to do particularly well.

Mentioned in story

The S&P 500 is down 13% this year, and you’ve probably found yourself in a state of limbo, just waiting to see whether stocks will show signs of life or fall even more. Well, wait no more: those signs are right under your nose, and some stocks might benefit from any bounceback more than most.

What are the signs of life?

In April and May – i.e. the first two months of the second quarter – investment bank analysts cut their earnings per share (EPS) estimates for S&P 500 companies by an average of 1.3%.

That’s compared to an average cut of 2% by this time in a quarter over the past five years, and an average of 3% over the past 10. That makes this quarter’s trim pretty small – a good sign for stocks.

Source: FactSet

Another good sign: analysts have simultaneously been increasing their EPS forecasts – by 0.3% on average – for the second half of the year. Throw that together with the first-quarter EPS increases from earnings season surprises, and analysts’ overall profit forecasts for 2022 have increased by almost 1% in the past two months.

Source: FactSet

But what about inflation and interest rates?

Given the current macroeconomic backdrop – which has been dominated by rising interest rates, high inflation, and Russia’s war in Ukraine – you’d be forgiven for thinking this year’s stock market selloff would be accompanied by wholesale estimate cuts too. But with EPS forecasts up and share prices down (meaning their price-to-earnings ratios have fallen), US stocks now represent better value than they have in some time.

What’s more, an analysis we published in April (and that others are starting to agree with) suggests inflation is past its peak. That could mean future interest rate hikes this year and next won’t be as large or frequent as some investors expect. And since higher interest rates generally make stocks less attractive than some other assets, not-so-high rates could give yet another boost to stocks.

So what’s the opportunity here?

I’d take a two-pronged approach, focusing on US stocks with momentum and quality. Momentum matters because rising earnings estimates, should they prove right, are usually followed by rising share prices when companies report earnings. And quality matters because this year’s selloff may present opportunities to snap up shares of “high-quality” companies – i.e. those with a track record of high and stable profitability – at a discount.

To play momentum, I’d look at the sectors where analysts are raising earnings estimates the most: right now, that’s energy, materials, industrials, real estate, and financials. In spite of the headwinds the global economy is facing, analysts believe these companies will do better than they were forecasting just two months ago.

Source: FactSet

There are countless ETFs that allow you to buy into each of these sectors (check them out here). To name a few, you could consider the Energy Select Sector SPDR Fund (ticker: XLE) for exposure to stocks in the US energy industry; the Materials Select Sector SPDR Fund (XLB) to buy into the US materials sector; the Industrial Select Sector SPDR Fund (XLI) for US industrials; and the Financial Select Sector SPDR Fund (XLF) for US financials, including real estate. These all have low expense ratios of just 0.1%, making them worth taking note of.

To play quality, I’ve run a screen using free tool Finviz, where I’ve looked for large US companies (>$10 billion market cap) that screen well on several measures of quality: operating margin above 25%, positive return on equity and payout ratios, and with sales growth above 10% annually for the past five years. I’ve overlaid that with share price performance, looking for companies whose shares have fallen 20% or more this year in order to narrow the list to 19 stocks where there could be an interesting opportunity right now.

Some of the biggest names on the list include chipmakers Nvidia and Micron, financial services firms T. Rowe Price and Moody’s, and real estate investment trusts Life Storage and Medical Properties.

Source: Finviz
Source: Finviz

Of course, no two investors measure quality in exactly the same way, so feel free to take my screen here and make any adjustments you like.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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