Earnings results ahead may reignite a rally in cyclical stocks linked to the economy

Published Thu, Jul 15 202110:05 AM EDTUpdated Thu, Jul 15 202110:59 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Earnings season may be a springboard for some cyclical companies to regain market leadership. Profitability for companies in sectors like industrials, materials and energy was hit hard during the pandemic, when the economy abruptly shut down. Now a year later, some of those companies' second-quarter earnings are expected to double, triple or even jump fivefold from Q2, 2020. On top of that, analysts say earnings forecast revisions may have been too conservative, and cyclical and value names could benefit from big surprises. They are also the group of stocks that can be winners from inflation, since they have been able to pass on rising input costs to customers in the form of price increases. "We do think this is a time that cyclicals could respond more positively," said Julian Emanuel, head of equity and derivatives strategy at BTIG. After outpacing growth and tech when Treasury yields were rising earlier in the year, some cyclical sectors are actually negative in the last month while technology stocks have zoomed ahead by nearly 7%. For the year, tech has gained 17.3%, now surpassing materials, up 13.4% and industrials up 15.7%. Cyclical financials are up 23.7% for the year, and energy holds a 34.4% gain. "It's the combination of what we think is going to be a bottoming in yields based on the inflation data, and the whole idea that you had an entire group of cyclically oriented companies have their earnings revised upward in the second quarter and have stock prices with no reaction, or traded off because they got swamped in the noise of the bond market," said Emanuel. Emanuel said the stocks he highlighted going into earnings seasons included deep cyclicals. Citigroup , Caterpillar, Deere and Dow were on a list of stocks whose share prices have lagged since the start of the second quarter, but had earnings estimate revisions since March 31 in the top 20% of the S & P 500. During the second quarter, the widely watched benchmark 10-year Treasury yield fell from its March high of 1.77%. It was at about 1.33% Thursday, above the 1.25% hit last week. The yield moves opposite price, and many market pros had anticipated yields to rise as inflation readings got hotter and hotter this summer. Technology and other growth stocks are particularly vulnerable to higher yields and inflation concerns. Even so, technology has been the best performing major sector this week, even as June's consumer price index showed consumer inflation rising at an annual pace of 5.4%. Tech and growth are viewed as longer-duration holdings that will pay off in the future. Higher yields reduce the value of future cash flows. If investors shift their sights again to cyclicals, all cyclical groups may not benefit equally, but materials is one sector where there could be a pop. "Even with the rollover in commodities prices from the top, the profitability of those companies is near record highs and margins will be at all-time highs," said Adam Parker, founder of Trivariate Research. "You still have a generally good fundamental setup and you have a lot of profitability." Parker notes that some companies have had massive earnings revisions. Louisiana Pacific, for instance, was expected to earn $3.36 per share this year at the start of the year, but that has since moved up to an estimate of $12.40 per share. Similar, the estimate for Steel Dynamics was $3.12 per share for 2021, but it is now at $12.94 per share. "They're generating massive cash flow. I think they're going to improve their balance sheet pretty meaningfully this cycle. I definitely like energy and materials. That's the way to play inflation," Parker said. Parker identified stocks in the top 5% in terms of forecasted earnings expansion and in the top 5% of S & P 500 companies with forecasted multiple contraction, meaning simply that their price-to-earnings ration shrank and stocks look cheap compared with earnings. Some of these stocks include Olin , Micron Technologies, Alcoa, ExxonMobil, Western Digital and LyondellBasell Industries. Mosaic, Darden Restaurants and Discover Financial were also on the list. Parker notes that materials and retailers on average seem to have lower expectations and therefore have more potential to outperform earnings targets. "I'm pretty optimistic on the market," he said. "I really like energy and materials. I think generally that analysts haven't taken their numbers up enough, and there's some margin expansion there. I'm massively bullish on energy." In his second half outlook, Parker noted that oil prices were up 10% in June, and rising oil means higher earnings revisions and higher net income. "Earnings revisions are highly effective at picking winners from losers within the cohort for the 6-months following periods when oil is rising, meaning energy stocks beating estimates will likely perform strongly," he wrote in the outlook. "Additionally, despite the strong rally, the sector is quite cheap versus history on price-to-book, which was the most efficacious valuation metric for picking energy stocks historically." Parker added that oil prices have been a leading indicator for net income of the energy sector. The change in the price of West Texas Intermediate crude has typically been a three- to six-month leading indicator for reported net income of oil companies, he noted. Regarding the cyclicals, Parker is cautious on rate-sensitive banks, which have gotten pricier. He said for banks, net interest margins may not expand as much during the quarter as expected by managements when rates were higher in April. But Emanuel said he expects the bank stocks, which have been lackluster after earnings reports this week, to do better as the earnings period goes on. "Financials are very strange. If you go back even pre-pandemic, the financials have the habit of not responding in the immediate aftermath of earnings. In a way that is counterintuitive to what the reports say and what happens is we see time and again, the market reassesses their initial reaction," he said. "We think it's going to be the exact same thing this time." Some inflation is obviously a positive for earnings, but it may not be if it becomes persistent. "If anything could derail the equities market, it will be wage and input cost inflation that offsets revenue growth and pinches margins," Parker said. For now, he doesn't see a problem, and he's bullish. "Earnings are good. The economy is good. The Fed is helping out and there's fiscal stimulus," he said.

A trader works on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., June 30, 2021.

Brendan McDermid | Reuters

Earnings season may be a springboard for some cyclical companies to regain market leadership.