In fact, several underlying earnings trends support our thesis that cyclical stocks may start to outperform more defensive sectors over the course of 2013.
International focus not domestic
First, sectors with the largest increase in bottom-up fourth quarter earnings estimates since January include energy and materials. These more growth-sensitive sectors had lagged more cash-generative sectors such as healthcare and consumer discretionary stocks in the three months to end-January.
Second, more favourable earnings revisions ratio data for industrials and materials in January may suggest a brighter trend for analysts upgrading earnings outlooks rather than lowering them. As such, we believe that more cyclical, internationally exposed sectors of the US equity market may continue their January outperformance against defensive, domestic plays.
Technology, industrials and energy are presently BofA Merrill Lynch Research’s favoured sectors within the US equity market.
While the European season is not as close to completion as that of the US (only 20% of results have been released), data so far has seen European earnings closer to flat compared to prior expectations – €30bn of earnings have been reported, around 1% below analysts’ forecasts.
Positive earnings surprises have been particularly strong for European financials, driven by strong beats for several Spanish banks. This may be evidence that easier financial conditions, the product of ECB president Draghi’s commitment to do “whatever it takes to support the euro”, may be beginning to bear fruit.
We await more evidence on the evolution of European earnings but note from BofA Merrill Lynch’s European investment strategist, John Bilton, that European results so far (with 46% of companies beating earnings forecasts, below the third quarter level of 48%) signal stabilisation, rather than outright improvement.
Is investor sentiment overly positive on equities?
Nevertheless, earnings revisions ratios have recently risen for the first time in six months, potentially suggesting that as leading indicators also move up, earnings per share should improve in coming quarters.
There is potential for a retracement in global (including European) equity markets on a short-term basis, given another weekly inflow of funds for global equities last week (the longest streak of inflows in nine years, according to BofA Merrill Lynch’s Michael Hartnett). Signs are emerging that investor sentiment around equity markets may be overly bullish at present.
However, we feel that a number of factors may support cyclical European equity sectors over the long-term. Improving earnings revisions ratios for lower quality versus high quality European stocks highlight a potentially turning tide for cyclical elements of the European stock market.
Earnings beats in European value sectors (67%) have exceeded beats in quality sectors so far, suggesting a potential turn in fortunes for the more attractively valued sectors of the European equity market. Light investor positioning in higher beta sectors and supportive valuations may also favour previously unloved European equity sectors, such as basic resources, over more defensive sectors with more bond-like characteristics.
