- At an industry level, there is a wide dispersion in earnings momentum; negative revisions in commodities and technology are offsetting gains in other cyclical sectors
- A broader spread in P/E multiples means better opportunities for stock pickers.
At an index level, equities have little to show for themselves over the last year. From the peak on 20 September 2018 through 13 September,
- US equities have returned just 2.5%
- Europe ex‐UK 3.2%
- UK ‐0.7%
- Japan ‐8.5%
- emerging markets ‐1.0%.
Exhibit 1: Next-twelve-month (NTM) earnings estimates
Data as at 31 September 2019; source: FactSet, MSCI. (Price returns in local currency except EM in USD)
Most of those gains occurred in the first four months of year; since April, returns have been modest, with the UK and EM in negative territory.
At an index level, earnings expectations look... mwah
One explanation is limited earnings expectations. However, at an industry and stock level, things looks more appealing. Several industries have had positive earnings revisions, which have been offset by negative earnings revisions elsewhere. The bulk of the negative revisions have been in energy and materials. This is not surprising given the nearly 30% drop in oil prices and the 50% drop in natural gas prices from 2018’s highs.
Worryingly, these are the same sectors that suffered the biggest negative revisions at the end of 2018. Additional weakness is evident in banks, and Europe ex‐UK cars and retailing.
There is broad positive momentum in most other cyclical sectors. Low interest rates are helping the construction materials industry. Most consumer‐related sectors are strong, as well as tech software and services. Rising earnings expectations should continue to support stocks in those industries.
And what do valuations look like?
Whether they make for a good investment, however, depends on valuations. Looking beyond the index, some industries are trading at below-average multiples. This has been rare over the last several years.
Looking at the median P/E of stocks in the index and how that compares to history, the range between the 25th and 75th quartile reflects the dispersion of multiples: the higher the spread between the quartiles, the greater the opportunity to find relatively inexpensive stocks to buy or relatively expensive ones to short. US stocks appear cheaper than they have in years. There is a wider dispersion between the more expensive and cheaper areas than there has been in 17 years.
Europe shows a similarly wide gap between the 25th and 75th P/E quartiles, both including and excluding the UK. While for Europe ex‐UK, the median P/E is slightly higher than the long run average, in the UK, it is lower than both the short‐term and long‐term average.
What industries offer the preferred combination of rising earnings estimates and relatively low valuations?
In the US and Europe, these are construction materials, healthcare, non‐bank financials, tech software & services, and media & entertainment. Consumer discretionary is more appealing in the US, whereas it is consumer staples in Europe (and multiples are not as stretched as in the US).
So what appears to be a dull market with flat prices and poor earnings momentum turns out to be one with a lot of opportunity if you just look below the index.
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