Profitability in industries such as industrials, materials, and energy took a hit during the pandemic, when the economy abruptly shut down. After a year, some of those companies’ second-quarter earnings are expected to double, triple, or even fivefold compared to Q2, 2020.
Furthermore, analysts believe that earnings forecast revisions may have been too conservative, and that cyclical and value stocks may benefit from large surprises. They are also among the stocks that may benefit from inflation because they have been able to pass on rising input costs to customers in the form of price increases.
“We do believe this is a time when cyclicals may respond more positively,” said Julian Emanuel, BTIG’s head of equity and derivatives strategy.
After outperforming growth and technology when Treasury yields were rising earlier this year, some cyclical sectors have actually turned negative in the last month, while technology stocks have surged by nearly 7%. For the year, technology has gained 17.3 percent, surpassing materials, which have gained 13.4 percent, and industrials, which have gained 15.7 percent. Cyclical financials are up 23.7 percent year to date, while energy is up 34.4 percent.
“It’s a combination of what we believe will be a bottoming in yields based on inflation data, and the whole idea that you had an entire group of cyclically oriented companies have their earnings revised upward in the second quarter and have stock prices with no reaction, or traded off because they got swamped in the noise of the bond market,” Emanuel explained.
Deep cyclicals, according to Emanuel, were among the stocks he highlighted as earnings season approached. Citigroup, Caterpillar, Deere, and Dow were among the stocks whose share prices have lagged since the start of the second quarter but have had earnings estimate revisions in the top 20% of the S&P 500 since March 31.
The widely followed benchmark 10-year Treasury yield fell from its March high of 1.77 percent during the second quarter. It was around 1.33 percent on Thursday, up from 1.25 percent the previous week. The yield moves in the opposite direction of the price, and many market experts expected yields to rise as inflation readings rose this summer.
Higher yields and inflationary concerns are particularly dangerous for technology and other growth stocks. Despite this, technology has been the best performing major sector this week, despite the fact that the consumer price index rose at a 5.4 percent annual rate in June.
Technology and growth are viewed as long-term investments that will pay off in the future. Higher yields devalue future cash flows.
If investors return their focus to cyclicals, not all cyclical groups will benefit equally, but materials is one sector that could see a surge.
“Even with the rollover in commodity prices from the top, those companies’ profitability is near record highs, and margins will be at all-time highs,” said Adam Parker, founder of Trivariate Research. “You still have a good fundamental setup overall, and you have a lot of profitability.”
Parker points out that some companies have had significant earnings revisions. Louisiana Pacific, for example, was expected to earn $3.36 per share this year at the start of the year, but that figure has since risen to $12.40 per share.
Steel Dynamics was expected to trade at $3.12 per share in 2021, but it is now trading at $12.94 per share.
“They’re generating a lot of money. This cycle, I believe they will significantly improve their balance sheet. I am a big fan of energy and materials. That is how you play inflation,” Parker explained.
Parker identified stocks in the top 5% of S&P 500 companies in terms of forecasted earnings expansion and in the top 5% of S&P 500 companies in terms of forecasted multiple contraction, which simply means that their price-to-earnings ratio shrank and stocks appear cheap in comparison to earnings.
Olin, Micron Technologies, Alcoa, ExxonMobil, Western Digital, and LyondellBasell Industries are among these companies. Mosaic, Darden Restaurants, and Discover Financial were also among the companies on the list.
Parker observes that, on average, materials and retailers appear to have lower expectations and thus have a greater potential to outperform earnings targets.
“I’m fairly optimistic about the market,” he stated. “I am fascinated by energy and materials. I believe that, in general, analysts have not raised their estimates sufficiently, and that there is room for margin expansion. I’m a huge believer in energy.”
Parker noted in his second-half outlook that oil prices were up 10% in June, and rising oil means higher earnings revisions and higher net income.
“For the 6-months following periods when oil is rising, earnings revisions are highly effective at picking winners from losers within the cohort, implying that energy stocks beating estimates will likely perform strongly,” he wrote in the outlook. “Additionally, despite the strong rally, the sector is quite cheap compared to history on price-to-book, which has historically been the most effective valuation metric for picking energy stocks.”
Parker went on to say that oil prices have been a leading indicator of the energy sector’s net income. He noted that the change in the price of West Texas Intermediate crude has historically been a three- to six-month leading indicator for oil companies’ reported net income.
In terms of cyclicals, Parker is wary of rate-sensitive banks, which have become more expensive. He predicted that when interest rates rose in April, banks’ net interest margins would not expand as much as expected.
However, Emanuel believes that bank stocks, which have been underperforming following earnings reports this week, will improve as the earnings period progresses.
“Money is a strange thing. Even before the pandemic, the financials had a habit of not responding immediately after earnings. In a way, that contradicts what the reports say, and what we see time and again is that the market reassesses their initial reaction,” he said. “We believe it will be exactly the same this time.”
Some inflation is obviously beneficial to earnings, but if it becomes persistent, it may not be.
“If anything can derail the stock market, it will be wage and input cost inflation, which offsets revenue growth and squeezes margins,” Parker said.
For the time being, he doesn’t see a problem and is optimistic. “The pay is good. The economy is doing well. “The Fed is assisting, and there is fiscal stimulus,” he said.