The Wall Street Mood Monitor is a three-factor model gauging the climate or “mood” for active management within each sector. The factors include sentiment, earnings trends and correlations. Sectors in the top right represent areas where active management conditions may be favorable based on positive earnings surprises and positive analyst sentiment, as measured by the number of upward revisions during the quarter. Correlations are assessed by comparing each sector’s current intra-sector correlations to its historical average. Larger circles represent lower correlations.
Below we examine the three components of the chart in more detail, including earnings, sentiment and correlations.
Earnings Surprises Near Record Highs
Corporate earnings closed 2017 on a high note—beating expectations at a near record clip.
In the fourth quarter, 55% of companies beat their consensus estimates by at least one standard deviation. The high rate of substantial earnings beats eclipsed the third quarter total (54%) and is close to the 15-year high established in June.
Meanwhile, only 11% of companies reported earnings substantially below their consensus estimates this quarter, which approaches the nadir reached in 2010.
By one measure, this may have been the best corporate earnings season in our 15 years of collecting data. The spread between companies reporting one-standard deviation beats and one standard deviation misses is now the widest we’ve ever recorded.
Analyst Sentiment Shifts Positive
As earnings continued to surprise, and tax reform looked more plausible, Wall Street analysts became far more optimistic about future earnings prospects.
The proportion of Wall Street analyst earnings estimate revisions that were adjusted upward improved each month. In December, 62% of all revisions were upward adjustments—the highest level since 2011.
In aggregate, the proportion of upward revisions exceeded downward revisions in 8 of 11 sectors. The technology, energy and consumer staples sectors enjoyed the highest rates of upward revisions.
The overwhelmingly positive view from analysts marks a step change in sentiment from last quarter, when the ratio of upward and downward revisions was neutral in July and August, and more negative in September.
Correlations Drop Dramatically
The most impressive change within this quarter’s Mood Monitor may be the dip in correlations.
Intra-market correlations were already near 15-year lows and plummeted even further this quarter. For perspective: correlations are now 20% below any level we have measured in 15 years. Over the past year, the average correlation between stocks has declined to only 0.29. That’s more than 40% below the average correlation observed since 2002.
Pundits can ascribe the drop to several potential factors: low market volatility, ebbing flows into passive, dramatic disparity between growth and value factors, or tax reform’s varying impact on individual companies. Whatever the reason, the market appears to be taking a more discerning view on individual companies.
Technology: Tech Sector Stands Out
While conditions for active management are now favorable across most sectors according to our model, the Technology sector offered active managers the best opportunity.
Similar to last quarter, Wall Street sentiment toward the sector remains positive with a higher rate of positive earnings revisions (73%) than any other sector.
Earnings trends were also most favorable in the Tech sector with 74% percent of companies delivering earnings surprises this quarter, far outpacing the health care sector (59%), which had the second-highest rate. Notably, the ratio of one-standard-deviation earnings surprises to one-standard-deviation misses reported within the sector is nearing its highest level in nearly a decade.
Intra-sector correlations are the third factor our model uses to assess active management conditions, and is an area where the Tech sector has shown vast improvement. In September 2017, stock correlations within the sector were hovering around their long-term average. They are now approaching their lowest level since we began observing intra-sector correlation data in 2002.
Energy: Best Conditions in a Decade?
While tech stands out as the brightest sector for active managers, conditions in the Energy sector are also favorable. In fact, when looking at all three factors together, conditions within the sector may be better now than at any point in the last decade.
Sentiment in the Energy sector gradually improved in the back half of 2017. As the chart shows, the sector hasn’t enjoyed such a high proportion of upward earnings estimate revisions since 2008.
Earnings trends within the sector have also improved substantially. Fifty-six percent of energy companies reported earnings surprises this quarter, compared to only 12% that reported earnings misses. To put that disparity in perspective, the delta between energy companies reporting substantial beats and misses is near its widest level in 15 years. In fact, the gap between energy companies that reported one-standard deviation earnings beats and misses was this wide only briefly in 2005, 2007 and 2015.
Stock correlations within the sector, meanwhile, remain well below their historical averages.
This piece is not intended to provide investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or sector by 361 Capital or any third-party.