Introduction

The 3rd quarter earnings cycle could bring record earnings growth, it's also a peak in the earnings growth cycle, and that has the market nervous. The threat of peak earnings is compounded by US/Sino trade-relations, rising interest rates, and a downgrade to global growth estimates. The IMF downgraded their world GDP growth estimate for 2019 by 0.2% to 3.7%, but still a strong a figure, and one that suggests corporate earnings growth will continue next year.

Regardless of the fear, long-term fundamentals are firmly skewed in favor of bull market conditions. On the economic front, growth is still accelerating broadly and supported by a robust labor market, no reason to think a meaningful recession is on the way. That being said, I have started to suspect there may be a labor-led recession due to super-tight conditions. There simply aren't enough able and willing bodies to fill all the job openings that are available, and that fact offsets economic potential of those jobs.

The Atlanta Fed's GDP Now estimate has been trending lower over the last quarter but still shows an expectation for strong growth. The latest read has GDP estimates ticking higher as fresh data comes in stronger than expected. The tool now shows growth holding steady near 4.2% and possibly coming higher as activity accelerates into the fourth quarter holiday shopping season. The Conference Board says GDP will run at 3.8% for the fourth quarter which means growth could decelerate sharply toward the end of the year.


The 3rd quarter earnings cycle is about to ramp up to high gear and are high. Not only are we expecting earnings growth we are expecting robust double-digit earnings growth and for double-digit growth to continue for the next five earnings cycles at least. Despite the market fear, the estimates for next year are on the rise having pushed the full-year estimate to 10.4%. The only thing wrong with this picture is that the earnings growth acceleration is expected to top out this cycle which could drag on the indices over the next two quarters. The good news, aside from double-digit earnings growth, is that growth is expected to begin accelerating as soon as the second quarter of 2019.


All 11 S&P sectors are expected to show growth in the 3rd quarter. A full ten of those sectors have seen negative revision since the start of the quarter, but those revisions are very small in most cases. The consumer staples are the only sector revised higher since the start of the quarter. Based on past performance, I expect to see most if not all sectors beat their estimates this cycle. The average amount of upward revision for the entire S&P 500 is nearly 5% which means we could see growth top out near 23.5% by the end of the quarter.


Looking to future quarters the estimates for earnings growth are good, if lower than current, and mostly on the rise. The fourth quarter is now expected to post 17.1%, down from a peak near 21%, but still quite strong. Looking to next year growth will fall to about 7.5% in the first half, bottoming in the first quarter and then expanding in the second.


The S&P 500 Technical Outlook

The S&P 500 achieved a full recovery of the February 2018 correction since the last earnings cycle. The index moved up to hit a new all-time in late August and has since fallen from that peak. The index is now in a correction that may turn into a trading range if earnings results do not please the market. Regardless, so long as earnings growth remains in the forecast dips are opportunities to buy.


The daily chart shows an index recoiling from new highs and poised to move lower. The move has broken a couple of key support targets and could lead to a much deeper decline, possibly as low as 2,700, before strong support kicks in. The takeaway is that the index corrected just before peak earnings and presenting a nice entry point for near, short and long-term positions should earnings satisfy the market. At this time I think it best to wait for earnings and watch for the next signal to develop.


Second Quarter Earnings; Sector By Sector

The Energy Sector (XLE)

The energy sector is still the biggest story in earnings growth. This quarter the sector is expected to see earnings grow at a rate near 95% and could easily top estimates. The growth is driven by rising prices for oil and expected to continue over the next five quarters. Not only is there growth for the next five quarters estimates are on the rise for all quarters and leading the sector higher. The only downside is that earnings growth will fall sharply from this years roughly 100% annual rate to about 27.5% in 2019. Regardless, the energy sector is expected to post the highest level of growth next year and more than double the number two consumer discretionary spot.

I was bullish on energy last quarter, and that was OK, the sector moved up to hit my first target before the late summer correction in oil prices brought the sector down. The Energy Sector SPDR is now testing support at the long-term moving average and may go lower although support seems to be holding now. The indicators are consistent with a move lower, so a move to the bottom of the six-month range at $72 is possible. Longer-term the sector is expected to post robust earnings growth for at least the next five quarters, and oil prices are high, so I expect to see support kick in soon if it isn't already. Cautiously Bullish.


The Financial Sector (XLF)

The financial sector jumps back to second place regarding expected earnings growth. The sector is estimated to produce growth near 34% this quarter and well above second place Materials. The financial sector is supported by accelerating activity in both business and consumer services. The caveat is that rising rates, while good for earnings, is bad for economic activity and will curb earnings growth in coming quarters. The fourth quarter of 2018 should see growth in the range of 22.5% (second highest for the quarter) with that number tapering off next year for an average of 10.1% in 2019.

The Financial Sector SPDR XLF moved up over the last quarter as expected and then topped out along with the broader market. The ETF is now trading near the bottom of a long-term range and exhibiting signs of support ahead of what is expected to be a strong earnings season. The ETF may move lower, but it will be within a near-one-year trading range until it moves below $26.40. If the ETF can find support at the current level resistance is near $28, a move above that could be bullish. Neutral Bullish


The Materials Sector (XLB)

The materials sector had been running a strong second place regarding earnings growth but has fallen to a distant third in the third quarter. The sector is expected to see a growth of 26.8%, strong, but not as strong as energy or the financials. Moving forward to next quarter growth will slow again to 12.2% putting materials in #6 spot relative to the eleven S&P 500 sectors. Earnings growth deceleration will continue into 2019 with full-year estimates running near 6.9% putting materials down another spot to #7. My take, economic expansion is everywhere you look so it is no wonder the sector is doing well; people need materials, and Congress just passed a resolution to double infrastructure spending worldwide. The sector may not see growth accelerate as it did over the last year but I think it will see steady business for the next few years.

I was neutral on the XLB Materials Sector SPDR, and the ETF held within the expected range for most of the quarter. It has entered a correction along with the broader market and now trading at a just-over one year low. The ETF is now sitting on the long-term support near $54 and indicated to remain within the range. This means we may see prices snap back and if so it could be a strong one. A move up may find resistance at $56 and $58, a move lower may take the ETF down to $50. Neutral Bullish.


Communication Services (XLC)

S&P reshuffled the deck over the summer and spat out the Communication Services Sector. The sector replaces the Telecom Sector and is different in that it is heavily weighted toward the Internet and Facebook is the number one holding. I guess that tells you how important Facebook is to America, sad but true. Regardless, the sector is expected to post the fourth-highest earnings growth this quarter and expected to see some of the mildest deceleration over the next year. The fourth quarter estimate is near 16.5% and then an average 10.5% for all of 2019. Considering the privacy and trust issues related to social media, I would expect this sector to see some regulatory hurdles develop in the not too distant future.

The XLC Communication Services SPDR has been trending lower since its launch four months ago. The sector is now down more than -12% from inception and poised to move lower is earnings outlook and/or fear of rising rates does not improve. Because this sector is so new, I will refrain from making a technical call until there is more price data to chart. Using FB as a proxy, that stock is now down -30% and about to test key support near $150 and the long-term 150-day moving average. Neutral.


The Info/Technology

The information/technology sector has been one of the best performing over the past few years and is expected to continuing performing strongly over the next five quarters. The sector is estimated to produce the fifth strongest earnings growth in the third quarter, the fifth strongest for the year and next year. The only negative in the outlook is that growth will decelerate from an average of 16.8% in the current quarter to about 10.5% next quarter. The good news is that growth will hold steady near 10.0% for all of 2019.

My target of $75 was reached over the last quarter but produced significant resistance in the face of rising interest rates. The sector is now in correction along with the broader market and heading down to seek support. The caveat is that the XLK Technology SPDR has fallen below the long-term moving average and looks like it could go lower. The indicators are consistent with lower prices, but there is evidence of support at this level too. If the ETF continues to fall and closes below $69, it could move to $66. A move up would be bullish and indicate support but may not result in a strong bounce. It is possible this sector and the broader market may have entered a trading range that could last for the next couple of quarters. Neutral.


The Industrial Sector (XLI)

The earnings outlook for the industrial sector is interesting, to say the least. Of the six sectors I've touched base on so far, it is the only one expected see earnings growth accelerate in the next quarter. The sector is looking at growth near 15% for the third quarter and then 20.5% in the fourth. Growth will decelerate in 2019 but down to an average 12.6% which puts the industrials in third place relative to the eleven S&P 500 sectors.

I was cautiously bullish on the industrial sector last quarter, and it exceeded my targets smartly. The XLI Industrial Sector SPDR is now in correction along with the broader market, confirming resistance at the $80 level, and may fall further. If it does, or if it confirms support at current levels, I will view it as a buying opportunity for long-term positions. Resistance is near $76 and then $78 if prices can rebound. I am cautiously bullish on this sector but would wait for stronger signals before entering short-term bullish positions. Cautiously Bullish.


Consumer Discretionary (XLY)

The Consumer Discretionary sector has been my top pick regarding earnings growth and the outlook for several quarters, and it is still high on my list. The sector, like the industrials, is expected to see earnings growth accelerate this quarter and next (4th quarter 2018) before peaking out in 2019. The full 2019 outlook is also robust at 12.8% which puts the sector in #2 spot overall.

I was bullish on the XLY Consumer Discretionary Sector SPDR last quarter and am still bullish today. The ETF exceeded my target over the last quarter and is now in correction along with the broader market. The ETF is now trading below the long-term moving average where it is an attractive buy. The caveat is that the correction/corrective action is probably not over and may produce an additional, possibly lower, entry to this sector. Support may be at $107.50, a move below that may find support at $105.00. Resistance is the long-term moving average near $110, a move above that would be bullish and trend-following. Cautiously Bullish.


The Healthcare Sector (XLV)

Based on demographic trends it is also expected to see steady expansion over the next two decades as the US population grows and ages. Regarding earnings growth, the healthcare sector is going to see earnings continue to accelerate into the fourth quarter before peaking out in 2019. This cycle is estimated to produce about 9.0% earnings growth; the next should see growth top 11.5%. Looking to next year, the healthcare sector should see growth near 8.5%.

I was bullish on this sector last quarter, and I am bullish on the sector this quarter. The XLV Healthcare Sector SPDR moved up to exceed my target, set a new all-time high, and is now retesting support at the previous all-time high. The sector may move lower to test the $90 level or lower and if it does, good, lower prices. If not, a move up from this level would help confirm support, a move above the short-term moving average will be bullish. Cautiously Bullish.


The Utilities Sector (XLU)

The utilities sector is expected to maintain earnings growth over the next six quarters, but the outlook is not rosy. The sector is expected to post growth of 6.7% this quarter and then accelerate to 8.8% next quarter, the part that isn't rosy is that growth will decelerate to only 4.2% next year which will make it the slowest grower of earnings in the market. What it has going for it right now are dividends (the XLY pays 3.3% compared to 1.80% with the SPY) and non-cyclical safe-haven appeal.

I was bullish on this sector last quarter because of safe haven appeal, and I am still bullish on it today. My target at $54 was exceeded but resistance set in at the $55 level. A correction followed that took the ETF down to the long-term moving average and a bounce has formed. The ETF is now retesting the short-term moving average for support and looks bullish. A bounce from this level would be trend-following, a move above $55 would be bullish. Cautiously Bullish.


The Real Estate Sector (XLRE)

The real estate sector is expected to produced earnings growth over the next two years, but it is not going to be a market leader. It is expected to have the 10th slowest earnings growth in the third quarter, about 6.6%, with growth holding near that level over the next few quarters. Next quarter, fourth quarter 2018, earnings growth is expected to accelerate to 8.9% before topping out. Growth will decelerate in 2019 to an average rate of 5.8% which is still OK but maybe not OK enough to fuel a rally. On the plus side, the XLRE Real Estate SPDR yields about 3.7% at current levels, near $31.25, a factor that will lend support over the long term.

I was bullish on the XLRE Real Estate Sector SPDR last quarter, and my target was hit. The $34 level turned out to be resistance, and the ETF has since fallen into a correction. The ETF is now heading down to strong support targets near a key uptrend line. Support is probably going to be near $31 or $30.75, or just below, a move below $30.50 could be bearish, but I'd be careful about new positions without market confirmation. If prices can find support as I think they will a move will likely find resistance at $32.50. I am firmly bullish on real estate for the long-term but see the sector's equities trading within a range in the near to short-term. Neutral.


Consumer Staples - XLP

The consumer staples sector isn't seeing robust earnings growth, but it is seeing steady, long-term, sustained earnings growth that is not expected to peak until next quarter. The sector is expected to see earnings growth near 5.5% this cycle, 6.4% next cycle and then an average 5.5% for all of next year. These numbers make the sector the most steady of all the sectors regarding growth and that is fueling dividends share buybacks. While earnings growth is tepid compared to the broader market, 5.5% is still good and supported by two things that could spur upside surprises; improving labor markets and an expanding population. While not a huge growth opportunity this is another safe sector with above average yield investors will turn to during the rotation out of growth names.

I was neutral, leaning toward bullish on the Consumer Staples SPDR last quarter and that turned out to be a good choice. The sector trend upward moved above the moving averages, and then found resistance near $55. The ETF is now in correction along with the broader market and heading down to support levels possibly as low as $52. A move below that would be bearish but I think waiting to see earnings reports from some of the big names in the sector before making a decision is a good idea. A move above $54 would be bullish if supported by earnings and outlook. Neutral Bullish.


My Conclusion

The broad market may be seeing a peak in earnings growth, but it is not an event affecting all sectors. The industrials, consumer discretionary, healthcare, utilities, real estate, and consumer staples sectors are all expected to see earnings growth accelerate in the fourth quarter. That's seven sectors, more than half the market, and reason for me to think the market will snap back from this correction. When it does, I don't think we'll see the same names leading that we've seen in the past. The age of wicked growth is over; now it's time for the market to focus on steady growth, income and value names in some of the non-cyclical and consumer-oriented sectors.

I remain firmly bullish on the S&P 500 for the long-term because we are in a secular bull market fueled by demographic trends. In the near-term, I am also bullish but very cautious. If today is the low of the correction, I think it will be retested before the correction is over. If today isn't the low of the correction, there will be a better time to buy. In either case, it's too early to get aggressively bullish, so caution is best.

Until then, remember the trend.

Thomas Hughes