The Wall Street Mood Monitor is a three-factor model gauging the climate or “mood” for active management within each sector. 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. Correlations are assessed by comparing each sector’s current intra-sector correlations to its historical average. Green circles represent lower-than-average correlations. Red circles indicate a correlation above the sector’s 15-year history. Circle size represents the magnitude of difference between current correlation and its long-term average (i.e., smaller circles correspond to lower magnitude differentials).
Below we examine the three components of the chart in more detail, including earnings, sentiment and correlations.
Earnings Continue on Hot Streak
Corporate earnings are riding a hot streak that deserves a multiyear perspective to fully appreciate. By some measures, the earnings environment has rarely been stronger.
In the second quarter, 53% of companies reported an earnings surprise, up slightly from 49% in the first three months of 2019. Meanwhile, only 12% of companies reported an earnings disappointment, slightly less than the 15% in the prior quarter.
Looking at the multiyear trends puts more shine on those numbers. One way to get a sense of the earnings environment is to look at the gap between the percentage of companies reporting earnings surprises vs. those reporting disappointments. That gap has grown consistently wider for the better part of the last four years, and hovers near 15-year highs achieved in September of 2018.
But Wall Street is Still Skeptical
Businesses continue to deliver impressive earnings results, but another trend also continues: Wall Street analysts don’t believe the hot streak can continue. On a monthly basis, we compare the cumulative upward and downward revisions sell-side analysts make to corporate earnings estimates. Only once in the past 10 months have positive revisions outpaced negative revisions.
Worse yet, in June, the negative revision rate exceeded the positive revision rate by 31%. That’s the worst mark since January 2016. The highest negative revision rates were in some of the most cyclical sectors: Materials, Energy and Industrials. The Health Care and Real Estate sectors were the only ones in which positive revisions outnumbered negative revisions.
Correlations Came Down from Q1
Intra-market correlations now hover near their long-term averages but for active managers, that’s a reprieve from the prior quarter. As market volatility ebbed and the prospects of accommodative Fed policy improved, correlations came down from 0.60 at the end of March to 0.51 at the end of June. That level is slightly lower than the long-term average of 0.55.
We also analyze stock correlations within each sector. Here, the picture varies. Intra-sector correlations are significantly below long-term averages in the Communication Services and Consumer Staples sectors. Meanwhile, Technology and Health Care intra-sector correlations remain considerably above long-term averages.
Sector Spotlight: Health Care and Communication Services
Currently, the conditions for active management don’t offer a Goldilocks scenario within any sector. We gauge the active management backdrop for each sector by measuring three factors: correlations, sentiment and earnings trends. No sector scored favorably on all three factors this quarter, but Health Care and Communications Services scored quite well on two.
Health Care: Earnings Trends, Analyst Sentiment Are Both Bright Spots
Health Care was one of only two sectors in which Wall Street sentiment was high, as 55% of all analysts’ changes to earnings estimates were upward revisions. Earnings trends for the sector were also strong: Fifty-nine percent of health care companies reported an earnings surprise in the second quarter, while only 7% reported an earnings disappointment. Only the Information Technology sector enjoyed a wider gap between the percentage of companies reporting earnings surprises and disappointments.
The lone sore spot for active management conditions in the Health Care sector is correlations. For the second consecutive quarter, no sector experienced higher intra-sector correlations relative to its long-term average.
Communication Services: Earnings Surprises Surge
The most notable trend in the Communication Services sector is the sudden surge in earnings strength. Positive surprise rates jumped by 22% in the second quarter, and the percentage of companies reporting surprises now sits well above its historical average. The sector is one of the smallest in the Russell 1000 Index, and fewer companies makes a surge or drop in earnings surprises and disappointments more likely, but the increase this quarter is nevertheless notable.
Low intra-sector correlations within the Communications Services sector also offer potential for active managers. The sector is currently experiencing lower correlations relative to its long-term averages than any other Russell 1000 sector. However, sentiment toward the sector is low, as 60% of all changes to analysts’ earnings estimates within the sector were downward revisions.
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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.
Intra-market correlation measures the average correlation between the returns of each stock in the universe relative to the average return of all stocks in the universe. Intra-sector correlation measures the average correlation between the returns of each stock in a sector relative to the average return of stocks in that sector.