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What if we’ve already hit the bottom? Add to ...

By now, you’ve probably heard the prophets of profit doom.

They’ve been telling us, as the quarterly earnings-reporting season gets under way, to brace for the worst results since the recession ended in 2009. They’ve been preparing us for profits on the U.S. benchmark S&P 500 index to actually post a year-over-year decline of 1 to 2 per cent.

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But embedded in that dark cloud is a potentially silver lining: What if this is the bottom?

Riding the earnings cycle

Sam Stovall, chief equity strategist at Standard & Poor’s, argued in a report this week that the third quarter could well be the trough of the current earnings cycle. The consensus forecasts of analysts predict that S&P 500 earnings growth will turn positive again in the fourth quarter, and will accelerate in 2013.

If so, that has significant implications for which sectors of the market are poised to generate the best gains over the next two to three years.

Looking at earnings cycles since 1970, Mr. Stovall found that the traditionally cyclical sectors – consumer discretionary, energy, industrials, information technology and materials – generated the strongest returns during periods of earnings expansion. The traditional defensive sectors – consumer staples, health care, telecoms and utilities – were stronger during contractions.

This finding is hardly a revelation – we expect to see cyclicals outperform when the cycle is on the way up, and defensives take the lead when the cycle is on the way down.

But what was a bit of a surprise was that this summer’s rally was “led by the cyclical sectors at the expense of the defensive ones” – more the pattern of an earnings expansion than a time of contraction.

Mr. Stovall suggested that this “may be a preamble to the coming turn in the earnings tide” – an anticipation by the market that the earnings trough is at hand.

Premature rotation?

If that was the case, it may have been wishful thinking. Mr. Stovall’s own research indicates that at no time in the past 40 years has the earnings cycle hit bottom without multiple quarters of declining year-over-year earnings. And the troughs have typically been much deeper than the 1-to-2-per-cent dip expected this earnings season.

If, in fact, earnings haven’t bottomed, then defensive sectors may still have more legs – and cyclicals may have gotten way ahead of themselves over the summer.

“The primary focus of participants on company conference calls, in our opinion, will be finding out if [third-quarter] results will indeed be the trough in this earnings cycle and if forward quarters will exhibit a gradual acceleration in growth.”

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