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 Beats Hit Record Highs…Again
Companies continued to deliver good news on the earnings front. A record 60% of Russell 1000 companies beat consensus earnings expectations by at least one standard deviation in the third quarter. This marked the second straight quarter the rate of significant earnings beats reached record levels, and the first time in our 15 years of collecting such data that the earnings surprise rate hit 60%.
Conversely, only 11% of companies reported earnings that missed expectations by at least a standard deviation, near the low-water mark of the past eight years. The gap between the percentage of companies reporting significant beats and the percentage reporting significant misses is also at record levels.
At the sector level, the percentage of companies reporting significant earnings surprises hit 15 years highs in Technology, Health Care, and Communication Services.
Analyst Sentiment Hits Negative Territory
Corporations are shattering earnings expectations, but Wall Street appears skeptical the trend can continue. We gauge Wall Street sentiment by comparing the cumulative upward and downward revisions sell-side analysts make to their corporate earnings estimates. That sentiment turned sour this quarter.
Sentiment was already cooling in the second quarter, though upward revisions still outnumbered downward estimate changes. In September, however, the total percentage of upward revisions fell below 50% for the first time in 11 months.
Analyst enthusiasm waned most in the Materials, Financials, and Consumer Staples sectors. The Industrials sector experienced the highest percentage of upward earnings revisions, at 60%.
Correlations Turn Lower
Intra-market correlations dropped in the third quarter and are close to record-low levels established in November 2017. The dip follows a first-quarter spike that saw correlations rise above their 15-year average for the first time since mid-2016.
While correlations dropped in the third quarter, they likely rose again in October, as stocks sold off broadly because of concerns about rising interest rates and trade tensions between the United States and China.
Intra-sector correlations are below long-term averages in every sector except Communication Services, Real Estate, and Utilities.
Lower correlations imply higher stock specific risk which should create a more favorable environment for active managers with superior stock selection strategies.
Industrials: A Bright Spot for Active Management Conditions
Conditions within the Industrials sector appear most favorable for active managers. The sector scored well on all three factors we use to gauge the active management backdrop: sentiment, earnings trends, and correlations.
Sentiment was a bright spot for the industrials sector. We measure sentiment by comparing the total upward and downward earnings revisions Wall Street analysts make for companies within a sector. Sixty percent of industrial company earnings revisions were positive, a higher proportion of upward revisions than any other sector.
Earnings trends also remain strong for most industrial companies, with nearly two thirds of companies reporting earnings that were at least a standard deviation above consensus estimates. Only the Technology and Health Care sectors enjoyed higher rates of earnings surprises during the quarter. Relative to the sector’s historical norms, the ratio of industrial companies reporting significant earnings beats to those reporting significant misses is near its 15-year high.
Low correlations between individual industrial stocks should also provide opportunity for active managers. Currently, intra-sector correlations among industrial companies are near record lows established in late 2017.
Consumer Discretionary: Correlations Drop Sustantially
The Consumer Discretionary sector also scored well on all three of our factors. Intra-sector correlations among consumer discretionary stocks have only been this low twice in the last 15 years. As of the end of the third quarter, only the Health Care sector offers lower intra-sector correlations relative to its long-term average.
Analyst sentiment toward consumer discretionary stocks has dropped since the beginning of the year but remains positive, as slightly more revisions (51.5%) were upward than downward (48.5%).
Earnings trends within the Consumer Discretionary sector were also positive, with 58.5% of companies reporting earnings that were at least a standard deviation above consensus expectations.
While earnings trends for consumer discretionary companies are positive, the sector is hardly alone, as six sectors experienced a higher rate of earnings surprises than disappointments during the quarter.
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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.