Last week’s 7% increase for the S&P 500 might have provided comfort, especially when there were signs that inflation was starting to cool.
But now, right on cue, it’s time for bearish warnings to resume.
“As central bankers can drain liquidity faster than the economy can generate new production capacity, financial assets will continue to underperform physical assets like commodities,” according to Goldman Sachs analyst Jeffrey Currie. You can read more of his comments here.
An even broader reality check for investors was provided by Morgan Stanley Chief U.S. Equity Strategist Mike Wilson, who wrote in a note to clients that last week’s bounce would turn out to be “another bear market rally.”
According to this Bloomberg report, Wilson sees slowing growth as the biggest problem for investors. He believes earnings estimates are too high for U.S. companies, and if he is correct, investors who don’t want to ride through another downward cycle for stocks need to take some action.
During a year in which the price of West Texas Intermediate crude oil CL based on continuous forward-month contract quotes has increased 53% through May 27 to $115.07 a barrel and gasoline prices have soared, investors already know that commodities are a bright spot in a down market for stocks and bonds. But where might the growth be from here?
If you invest in exchange traded funds that focus on specific sectors, the following set of estimates may help you with your allocation over the next couple of years.
Over the long term, stock prices increase as companies’ profits rise. Since the stock market is forward-looking, the movement of consensus earnings estimates may be the most important driver for broad increases in stock prices.
So far this year, the S&P 500 energy sector has been the strongest of the benchmark’s 11 sectors, rising 58% through May 27 (excluding dividends), while the broad S&P 500 SPX is down 13%. Meanwhile, since the end of 2021, the weighted consensus earnings-per-share estimate for calendar 2022 for the energy sector has increased 69%.
Breaking down the S&P 500’s sectors
Before looking out through 2024, let’s set the table with movements of consensus EPS estimates during 2022:
| Sector | Change in EPS estimate | Estimated EPS – 2022 – May 31, 2022 | Estimated 2022 EPS – Dec. 31, 2021 | Forward P/E – May 31, 2022 | Forward P/E – Dec. 31, 2021 | Price change – 2022 through May 27 |
| Energy | 68.8% | $64.60 | $38.27 | 10.9 | 11.0 | 58.3% |
| Materials | 14.7% | $38.38 | $33.45 | 14.6 | 17.0 | -3.8% |
| Real Estate | 4.4% | $13.84 | $13.26 | 19.8 | 24.5 | -13.7% |
| Information Technology | 2.7% | $111.63 | $108.65 | 21.2 | 28.1 | -19.2% |
| Financials | 0.3% | $44.49 | $44.35 | 12.6 | 14.7 | -9.2% |
| Utilities | -0.3% | $17.45 | $17.50 | 21.2 | 20.8 | 4.7% |
| Health Care | -1.0% | $94.35 | $95.26 | 16.5 | 17.3 | -5.1% |
| Consumer Staples | -1.3% | $36.48 | $36.97 | 20.7 | 21.8 | -3.3% |
| Industrials | -2.5% | $42.44 | $43.52 | 17.7 | 20.6 | -10.0% |
| Communication Services | -7.0% | $11.89 | $12.78 | 15.9 | 20.9 | -24.9% |
| Consumer Discretionary | -14.1% | $41.88 | $48.77 | 25.6 | 33.0 | -25.5% |
| S&P 500 | 2.5% | $227.27 | $221.82 | 17.6 | 21.5 | -12.8% |
| Source: FactSet | ||||||
Notes for the first table:
- The S&P 500’s forward price-to-earnings ratio has declined to 17.6 from 21.5 at the end of 2021. The index’s forward P/E has averaged 15.7 over the past 15 and 20 years. So we may still be at a rather high P/E considering that the Federal Reserve is about to reverse course — shrinking the money supply by allowing its bond portfolio to run off.
- The energy sector’s forward P/E has actually declined slightly this year to 10.9, even as the consensus earnings estimates have shot up as the price of oil has soared. The energy sector trades at 62% of the full index’s valuation. For 15 years, the energy sector’s average forward P/E of 14 has been 89% of the full index’s average forward P/E. So the energy sector appears still to be trading at a relatively low valuation, despite this year’s breathtaking runup. Here’s an argument that if oil can stay above $80, the energy sector has plenty of room to run.
- Only four of the 11 sectors have had their consensus 2022 EPS estimates increase since the end of last year. Aside from energy, these are materials, real estate and information technology. The last two trade at significantly higher P/E than the full index.
So much for history. Let’s take a look ahead, with 2022 as our baseline, leaving the sectors in the same order:
| Sector | Estimated EPS – 2022 | Estimated EPS – 2023 | Estimated EPS – 2024 | Expected EPS change – 2023 | Expected EPS change – 2024 |
| Energy | $64.60 | $57.02 | $51.61 | –11.7% | -9.5% |
| Materials | $38.38 | $36.24 | $35.81 | -5.6% | -1.2% |
| Real Estate | $13.84 | $14.62 | $15.60 | 5.7% | 6.7% |
| Information Technology | $111.63 | $124.55 | $134.34 | 11.6% | 7.9% |
| Financials | $44.49 | $50.83 | $56.83 | 14.2% | 11.8% |
| Utilities | $17.45 | $18.87 | $20.31 | 8.1% | 7.7% |
| Health Care | $94.35 | $94.51 | $100.69 | 0.2% | 6.5% |
| Consumer Staples | $36.48 | $39.23 | $42.52 | 7.5% | 8.4% |
| Industrials | $42.44 | $50.73 | $56.54 | 19.5% | 11.4% |
| Communication Services | $11.89 | $13.81 | $15.80 | 16.2% | 14.4% |
| Consumer Discretionary | $41.88 | $57.16 | $65.74 | 36.5% | 15.0% |
| S&P 500 | $227.27 | $249.96 | $271.83 | 10.0% | 8.8% |
| Source: FactSet | |||||
The energy sector is bolded, because its weighted EPS are expected to decline over the next two years. Meanwhile, the financial, industrial, communication services and consumer discretionary sectors are expected to show double-digit increases in earnings in 2023 and 2024.
Energy might still be an early play
The energy sector is expected to see earnings drop off in 2023 and 2024. There are many moving parts, including increasing demand in China as its economy (hopefully) opens up from coronavirus restrictions.
If we were to apply those expected rates of EPS decline to the $115.07 price for a barrel of West Texas Intermediate crude oil on May 27, the price would be down to a shade under $92 in 2024 — well above where oil prices have typically been over the past 10 years. And that low P/E valuation may move closer in line with that of the S&P 500.
This is where your own opinion comes into play. If you believe oil will stay above $80 for several years, you might consider taking a position in a sector fund such as the Vanguard Energy ETF VDE.
VDE holds 100 stocks, while the S&P 500 includes only 21 energy companies because the low-price environment for oil before 2022 led to the removal of some companies that were formerly in the large-cap index. Some can be expected to move back into the S&P 500 as market capitalizations increase and the index is rebalanced quarterly. To stick with the benchmark index’s energy sector, consider the Energy Select SPDR ETF XLE.
Financials
The financial sector is down 9% this year, as investors are understandably conflicted. Rising interest rates should bode well for earnings, as the banks are flush with cash. They don’t need to pay much for deposits and their loan rates will reset higher.
But the countertrend is a possible recession as a result of the Fed’s tightening. That would mean increasing loan losses and a hit to earnings for the banks. Financials are trading at 72% the valuation of the S&P 500 — a typical level.
If you feel good about financials from here, consider the Vanguard Financials ETF for broad exposure across market cap ranges. For narrower bank exposure, you can look at the Invesco KBW Bank ETF KBWB, which tracks the large-cap KBW Nasdaq Bank Index BKX ; and the Invesco KBW Regional Banking ETF KBWR.
Industrials
What are you to make of a rapidly growing U.S. economy, with companies and consumers threatened by high inflation and the Federal Reserve tightening? Dick Bove, a bank analyst at Odeon Capital Group, expects a short recession, followed by a period during which he expects money “to flow to those companies that create real goods,” rather than to “financial constructs,” such as cryptocurrencies.
It would appear from the data on the second table that plenty of other analysts agree with him.
The industrials are trading in line with the full S&P 500 on a forward P/E basis. If you agree that in the next long economic phase for companies providing traditional goods and services are likely to be favored over innovators trading at much higher valuations, then the time may be ripe for the First Trust Industrials/Producer Durables AlphaDEX Fund FXR, which has outperformed the Industrial Select Sector SPDR ETF XLI by a good margin over the past 10 years.
Communications services
This is a sector industry in flux, as companies that had previously focused on subscriber or user growth in their financial reporting may now have to direct investors’ attention to revenue and profit. Netflix Inc. NFLX is a prime example — the stock is down 68% this year and now may be an excellent time to buy the stock.
The communications sector is broad — it includes AT&T Inc. T and Verizon Communications Inc., VZ but also Meta Platforms Inc. FB and Alphabet Inc. GOOGL, as well as traditional media companies.
Following a drop of nearly 25% so far in 2022, you might want to start dipping your toes into communications through the iShares U.S. Telecommunications ETF IYZ, which is heavily concentrated and focused on traditional telecom and networking companies. Its top five holdings (Verizon, Comcast Corp. CMCSA, Cisco Systems Inc. CSCO and AT&T) make up 53% of the portfolio. For broader industry exposure, stick with the S&P 500 sector with the Communications Services Select Sector SPDR ETF XLC.
Consumer discretionary
This sector includes plenty of retailers, but also Tesla Inc. TSLA and other auto manufacturers and several recovering industries, such as airlines, hotels and casinos. Analysts expect earnings for the consumer discretionary sector to rise by more than a third next year, with another 15% increase on tap for 2022. The Consumer Discretionary Select Sector SPDR ETF XLY is an obvious choice here, or for a narrower recovery play, take a look at the Invesco Dynamic Leisure & Entertainment ETF PEJ.
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