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: earnings, sentiment and correlations for the three months ending August 31, 2019.
Earnings Soften Slightly
We gauge the trend in Russell 1000 corporate performance by comparing the percentage of companies whose earnings exceed the consensus estimate by at least one standard deviation with the percentage of those that miss to the downside by the same degree.
Since a record 60% of Russell 1000 companies reported a significant beat in Q3 2018, the rate of upside surprises has fluctuated and dropped one percentage point to 52% for the three months ending August 31. That’s in line with the 12-month average and companies continue to surprise at a rate that is more than five percentage points higher than the long-term average.
The percentage of companies reporting an earnings disappointment climbed one percentage point to 13%, in line with the long-term average.
The percentage difference between companies reporting significant beats and those reporting significant misses has narrowed but continues to hover near a 15-year high hit in September 2018.
Analyst Sentiment Cools Further
Even as a majority of companies continue to post surprises to the upside, analysts are becoming more pessimistic. We gauge Wall Street sentiment by comparing the cumulative upward and downward revisions sell-side analysts make to their corporate earnings estimates.
There have been more downgrades than upgrades for the market in 11 of the past 12 months and August marked the fourth straight month that the negative revision rate exceeded the positive revision rate.
However, at -11% it was a considerable improvement over June’s -31%—the biggest gap since January 2016—although the revision ratio for the market excluding Health Care stocks would have been -15%.
Health Care, Communication Services and Real Estate were the only sectors where average revision ratios didn’t decline in the three months through August.
Geopolitical Risk Elevates Correlations
After falling to near-record lows in the third quarter of 2018, intra-market correlations climbed sharply in the final three months of last year on concern about issues including international trade tensions and the potential for slower global growth.
Ebbing volatility and expectations for Federal Reserve rate cuts pushed intra-sector correlations in the first two quarters of 2019 back below the long-term average of 0.55, before uncertainty about trade wars and the outlook for global growth re-emerged, taking total intra-market correlation at the end of August to 0.59.This represents an eight-point rise from the end of the second quarter and a five-point increase over the trailing three months.
Higher-trending correlations imply less significance for individual stock characteristics, a headwind for active managers. Lower correlations imply higher stock specific risk, which should create a more favorable environment for managers with superior stock selection strategies.
Sector Spotlight: Health Care and Communication Services
Health Care: Analyst Ardor Builds
Sentiment among Health Care analysts is positive and rising.
Analysts have raised their estimates for Health Care stocks for six straight months, making it the only sector to demonstrate significant optimism.
The sector was one of only two where the percentage of positive analyst revisions exceeded the percentage of negative revisions, at 62.1% versus 37.9%. The other was Utilities, where 52.2% of revisions were positive.
A significant earnings beat was posted by 72.8% of Health Care companies for the trailing three months, an almost 14 percentage-point surge from the prior period and the highest value we have measured since 2003. By comparison, just 5.8% of Health Care companies missed consensus earnings estimates by at least one standard deviation in the three months through August.
The only factor creating headwinds for active managers, looking at Health Care stocks, is intra-sector correlations which climbed to almost 0.60 to remain above the long-term average for the sector. However, since mid-2019 when correlations were approaching 0.75, intra-sector values have been declining toward the historical norm.
Communication Services: Sentiment Improves
Intra-sector correlations are above long-term averages for all sectors except Communication Services and Materials.
Correlations for Communication Services were unchanged in the three months through August at 0.61, below the historical norm for the sector, indicating these stocks also hold potential for active stock pickers.
Analysts are marginally less pessimistic about future performance, with 55.5% of all revisions to earnings estimates being downward in the period, a 4.5 percentage point improvement on the prior three months.
Positive earnings surprises have boosted sell-side sentiment, with 52.1% of companies reporting higher-than-expected profit compared with 14.6% that came in a standard deviation or more below consensus estimates, keeping positive surprise rates well above the long-term average for the sector.
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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.