A look at what the market is doing and where it may be going, sector by sector, from an earnings growth perspective.

Introduction

The market has been moving higher over the past few weeks, bouncing from long term lows and looking like it wants to go higher. This is good news for us bulls and when combined with the economic data and longer term outlook for GDP growth and earnings makes recent action in the major indices look like market reversal. The caveat is that not all sectors are doing as well others and some have better outlook than others, at the same time some sectors have declining earnings projections while others are on the rise. This is a look at the market on a sector by sector basis with earnings outlook and where they may be headed over the longer term.

In this run down I will be looking at the ETF's representing the 10 S&P 500 sectors and I will be using weekly charts. I will also take a look at earnings growth expectations for each sector and how they have been changing over the past month.

The S&P 500 - SPY

The broad market is bouncing and looks like it has reversed from the January/February bottom. Price action over the past 4 weeks shows a test of support at a long term trend line and a break above the 150 day moving average. The indicators are mixed but are consistent with a trend following bounce. That being said MACD remains in bearish territory and stochastic is still in the early phases of firing its trend following signal so there is a chance the index could return to retest support over the next few weeks or months. The 1,950 level could provide that support but it looks more likely buyers will step in along the up trend line, possibly as low as 1,900.


Part of what drove the index down to test the January/February lows is a decline in earnings expectations. In fact, the decline in expectations may be the primary factor with all other negative drivers only adding to the volatility we've seen over the past few months. Looking back to the middle of 2015 full year 2016 earnings growth for the entire S&P 500 was estimated in the range of 15%. This number has only fallen since then and today stands at only 2.8%.


On a quarter by quarter basis earnings projections have also been falling. First quarter expectations, which were positive as recently as December 31st 2015 (+0.5%) have fallen to -7.4%. Expectations for each of the following three quarters have also fallen steadily over the past few months leaving 2nd quarter projections in negative territory pointing to a fifth straight quarter of earnings declines.


This next table shows the decline in full year earnings growth estimates on a quarter by quarter basis for the 2nd, 3rd and 4th quarter of 2016. It is plain to see that growth expectations are in decline and falling, what is also plain to see and what is important to us is that starting with 2nd quarter negative growth is less bad and from that quarter forward positive earnings growth returns and expands into the end of the year and next year. 2017 earnings growth is projected in the range of 13%.


From this perspective it looks like we are in the bottom of an earnings recession with improving and positive outlook into the end of the year. The caveat is that it looked like we were in this position in the second half of last year and then oil prices sank to new lows. The difference between now and then is that oil prices appear to have bottomed and are 16% above the long term low.

The Energy Sector - XLE

The sector with the largest impact on negative earnings growth and earnings growth projections is of course the energy sector. This sector posted a decline of -60.3% in 2015, worse than first estimated, and that weakness is going to carry over into 2016. Full year estimates call for a -54.8% drop in earnings with a decline of -92.8% in the first quarter alone. To put the effect of oil prices into perspective 1st quarter projections fell from only -43.7% at the end of December. Rising oil prices will no doubt have an impact on these projections, if they begin to rise it will improve outlook for the entire S&P 500. Looking forward outlook for the energy sector is robust for 2017, +147% and up from the +64.8% predicted at the end of 2015.

Looking at the chart of the XLE we can see that the sector began to bounce from a 6 year low the very week that oil prices hit their low. Since then it has been moving higher and broke above potential resistance at the $60 this week. The indicators confirm the break above resistance and are firing a fairly strong entry signal. The next major hurdle to overcome will be the 150 day moving average. If oil prices continue to rise and/or earnings expectations begin to improve for the current quarter/year this hurdle could be easily overcome. Next upside target would then be the $70 level with a possibility of longer term rally.


Telecom - XTL

The next biggest drag on 2016 earnings is the telecom sector. The sector is expected to post an earnings growth decline of -6.2% for the entire year which, in light of the +13.5% projection for the 1st quarter, means it is expected to see declining earnings into the end of the year. Next year the sector returns to growth but only +4.4%.

Looking at the chart we can see the sector has been bouncing strongly since the broad market hit bottom in January. The sector has made four strong weeks of gains, nearly 18.5% from the low, likely driven on 1st quarter earnings expectations. The indicators are bullish and confirm the recent break above the 150 day moving average but considering the earnings outlook this run may be coming to an end soon. Resistance is likely to set in near the $58.50 level and will likely hold unless forward guidance improves.


Materials - XLB

The last of the three sectors expected to post negative earnings growth in 2016 is the materials sector. This sector is projected to see an earnings decline of -3.2%, down from the +9% estimate on December 31st, with the bulk of the decline seen in the 1st quarter. First quarter declines are projected at -19.5% and then improve into the end of the year. 2017 projections are positive and in fact are the second highest of all 10 sectors, +17%.

The sector has been moving higher in tandem with the broad market since hitting the January bottom. While gains have been strong they are also muted relative to the amount of decline seen since the market sell off began last year. The indicators are bullish and confirm the break above the 150 day moving average with next upside target near $46.50. Based on the long term outlook for earnings improvement this one appears to have room to run and may begin to attract new money with a real chance for significant upside in 2017.

The caveat is that current quarter and next quarter earnings are not going to be good and could easily spark a test of support which would provide a better entry than what is being presented today. First support target is the moving average, near $43.00 with next target near $42.50 and then $40.


Utilities - XLU

The sector with the smallest projected earnings growth for 2016 is the utilities. This sector is expected to grow earnings about 2.8%, down from the +7% predicted at the end of December, and that growth is expected to remain relatively stable into next year. 2017 growth is projected at 3.7%. The worst quarter for growth will be the current quarter which is expected to see a decline of -0.2%.

Looking at the chart we can see that the utilities have been moving higher since the January market bottom but are basically range bound over the past 16-18 months. The indicators are bullish and ticking higher so I would expect to see the XLU continue to move toward the high end of the range, possibly supported by dividend seekers. Based on the earnings outlook I expect to see it remain range bound into the end of the year and maybe even next year. Annual dividend on this ETF is about 3.5%, not great but better than the 2.10% paid by the SPY.


Industrials - XLI

The industrials are expected to be the third worst performing sector in the first quarter with an earnings decline of -10.9%. Despite this the sector expected to post growth for the full year and see that growth expand into 2017. Full year 2016 projection is for growth of +2.8% (down from 4% in late December) with that more than tripling to +9.3% in 2017.

The sector has been moving higher along with the broader market since hitting bottom in January and appears to be showing some strength this week. The sector has broken above the 150 day moving average with confirming indicators but with 1st quarter earnings expectations so low resistance is likely to be met in the near to short term. First target for resistance is near $55 with next target near $57.50. Depending on actual results the sector could see a pull back to support once first quarter earnings begin to come out. First target for support is near $52.50 and the 150 day moving average. The sector appears to be in a long term trading range and that range may hold until earnings growth returns to positive.


Consumer Staples - XLP

Consumer staples is expected to be the fourth best performing sector in the 1st quarter although projection are for a net decline in earnings. First quarter estimates are for a decline of -2.6%, down from about 5% in late December, with full year 2016 estimates at +3.3%. While weak this growth will still garner a top five spot for the year. Looking forward growth is expected to expand in 2017 to 9.6% making it one of 6 sectors whose 2017 estimates are on the rise. The state of the labor market has long been expected to spur consumer spending but as yet results are tepid at best.

Looking at the charts it appears that the market is banking on a continued improvement in the consumer. The sector broke out to a new high over the past three weeks and looks like it could keep moving higher. The indicators confirm the break to new highs with the caveat that stochastic is still trending near the middle of its range consistent with range bound asset. Momentum however is a stronger and both indicators are pointing higher. There is likely to be resistance at the under side of the long term trend line, the trend line broken in mid-2015, but so long as the labor market, earnings and spending shows improvement the sector could continue drifting higher.


InfoTech - XLK

The infotech sector is expected to be one of the best performing sectors for the year in terms of earnings even though it is also expected to be one of the worst performers in the first quarter. First quarter growth is projected at -7.3%, nearly -7% worse than projections at the end of the year, while full year estimates are in the range of 4.7%. Moving out to 2017 estimates increase to +11.9% and are on the rise from the end of last year. Based on these projections we can expect to see a fairly substantial turn around in earnings for the sector, perhaps starting as soon as the 2nd quarter.

Looking at the chart this sector looks like another one that has been range bound over the past year and half, and one that looks like it might remain range bound even with positive outlook. The sector has been moving higher since hitting the January bottom and has moved above the 150 day moving average this week but the indicators remain weak. Bearish momentum has receded to near 0 but remains bearish, stochastic is pointing higher in the nearer term and may be rolling over in the longer term but as yet has not. This set up, along with weak 1st quarter earnings projections, could easily lead to a retest of support in the near to short term with the possibility of rally later in the year. There may be resistance at the $42.50 level, if this level breaks then next target is at the 15 year high, near $44.50.


Health Care - XLV

The Health Care sector has been on a tear over the past year. It was the second best performing sector in 2015 and is expected to be the third best performing sector with estimated growth of 6.8%. The first quarter is going to be the weakest with estimated growth of 2.5% although that estimate has been falling as they have been with every other sector. Looking out to 2017 growth is expected to be fairly strong, about 11.5% but that too has come down from levels seen at the end of last year. My concern with this sector, and it is very real, is that many of the gains are likely tied to Obamacare and the future of it is in question. On the one hand a republican president is going to repeal the unaffordable care act, on the other more and more insurers are threatening to pull out the exchanges due to the unsustainable quality of the program. For these reasons alone I am staying away from this sector.

Now, in terms of the chart. The sector has been bouncing from the January bottom in tandem with the broader market but the technicals are weak at best and setting up for another sell-off at worst. The ETF is still below the 150 day moving average, the moving average is pointing lower, the indicators are weak, momentum remains bearish and stochastic %D is pointing lower. The sector may continue to drift higher while the broad market is moving higher but resistance is likely to be found at the moving average, just below $70. Support targets are near $65, $60 and $55.


Financials - XLF

The Financials are expected to be the second best performing sector in 2016 with earnings growth of 7.6%. On the flipside it is expected to be one of the worse performing sectors in the 1st quarter which means that growth and expanding growth is expected later in the year. Looking out to 2017 growth is expected to continue expanding in the range of 10% with those expectations ramping up over the last month. The risk here is the Fed, rate hikes and an uncertain regulatory environment; positive factors include economic trends, labor data and the consumer. What I expect is to see volatility in the sector with those banks with more exposure to the retail banking sector and the consumer doing better than others.

Looking at the charts it appears as if the sector has reversed from a February (Jamie Dimon) bottom although where it goes next is still questionable. This week saw the sector rise more than 4.5% and break above resistance at the $22 level although the indicators are not confirming. Stochastic is forming a weak bullish crossover, %K is crossing %D but %D is barely flattened and not yet rolling over, and MACD momentum is still bearish. This does not mean the ETF is going to head back to test its lows but it also does not indicate that upside is on the way. Any move higher will likely hit resistance along the 150 day moving average with a chance for consolidation at this level. What concerns me most with this chart is the convergence of bearish MACD with the February low which is typically indicative of a retest of that low.


Consumer Discretionary - XLY

The consumer discretionary sector has what may be the best expectations of earnings growth of all ten sectors, discounting the 143% projected for the energy sector in 2017. 1st quarter 2016 is expected to see +10.3% growth, full year 2016 is expected to see 11.2% growth and full year 2017 is expected to see 12.8% growth. The only negative I can see in the projections is that estimates for all three periods have fallen a bit since the end of last year. This growth is supported by the labor, earnings and spending data which has shown steady and stable improvement over the past year with little to no expectation of a decline in any going into the end of this year and next year. Based on the labor data and my read of the KC Fed's Labor Market Conditions Index we may in fact see an acceleration of labor market improvement and consumer spending going into the end of this year.

The chart looks OK, not as bullish as some but nonetheless promising. The ETF has been bouncing from the January bottom and has made some strong gains in the last four weeks. This week saw the sector break above the 150 day moving average and the moving average begin to tick higher. The indicators are mixed; MACD is still in bearish territory but rapidly approaching the zero line while stochastic is firing a bullish crossover after confirming support. First upside target is near $82 in the near to short term with a possibility of breaking out to new highs in the longer term. There is a possibility that support will be tested due to weak 1st quarter earnings expectation for the broad market but with sector expectations so strong into next year I think any such pull back will be muted.


Conclusions

Generally speaking I am bullish on the market into the end of the year and longer term into the end of 2017. I am also very cautious in my approach due to weak and declining expectations for the first half of this year. There may be another sell-off, pull back, dip or test of support in the near term but in my view this will be a buying opportunity for long positions with short to long term time horizons. Since next reporting season begins in 4 weeks with Alcoa on April 11th this is when I would expect to see the market begin to pull back.

On a sector by sector basis I am bullish on four of the ten sectors but waiting for new entry points; Energy (with the caveat that oil prices could fall again), materials, consumer staples and consumer discretionary. I am neutral on five sectors; telecom, utilities, industrials, info tech and financials. I am bearish on only one sector; healthcare.

What I am waiting for now is for earnings expectations for this year to begin to rise and they could begin to do that very soon. Oil prices and the energy sector have been the biggest drag on broad market expectations and now that they have bottomed (presumably) and moving higher expectations for the full S&P 500 are likely to be revised higher as well. When and if that begins to happen the entire market could rally.

Between now and then we have another FOMC meeting to wait on, another reason to wait for a possible pull back to support.

Until then, remember the trend!

Thomas Hughes