With 2016 wrapped up, equity investors can breathe a sigh of relief. The stock market is close to record highs thanks in large part to corporate profits, which are on their way up―finally.
For a long time, that wasn't the case. Corporate America was entrenched in an "earnings recession," where profits for the companies in the S&P 500 had declined (on a year-over-year basis) for six-straight quarters, the longest such streak since the financial crisis.
That streak was broken in Q3 of 2016, when earnings finally registered their first year-over-year gain since Q1 of 2015. The increase was modest―3.1%, according to FactSet―but it marks a turning point for profits, which are the lifeblood of the stock market.
In fact, with the increase, earnings for 2016 as a whole may turn out to be positive, but just barely. Corporations will begin to release fourth-quarter and full-year earnings in the middle of this month; current expectations are that S&P 500 companies will report another year-over-year gain for profits in Q4 of 2016, and a year-over-year gain for total 2016 profits.
Real Estate The Big Earnings Winner
For the full year, real estate is expected to be the biggest earnings winner, with an 18.6% increase. Consumer discretionary follows behind, with a 9.6% expected increase, then utilities at 7.5% and health care at 6.4%.
On the flip side, energy is the biggest earnings loser, with a massive 75.3% drop in profits expected, followed by telecom with a 7.5% decrease, materials with a 3.2% drop and industrials with a 3% decline.
Earnings & Performance Diverge
Given the mixed picture for earnings in 2016, one might expect that stock and ETF returns for the various sectors would be mixed as well. But as it turns out, every sector with the exception of health care rose in 2016.
That's not surprising, as the market tends to look forward. A weak 2016 for earnings doesn't necessarily translate into a weak 2017 (and vice versa). The most clear-cut example of that is the energy sector. In 2016, earnings for energy plunged by more than three-quarters, but in 2017, they are expected to surge a whopping 344% thanks to the recovery in oil prices.
That's why energy is the best-performing sector of the year. The Energy Select Sector SPDR Fund (XLE) returned 28.4% in the year-to-date period ending Dec. 29. As they typically do, investors are looking ahead rather than looking backward.
The same can be said for the stock market as a whole. While earnings for S&P 500 companies may end up flat or only slightly higher in 2016, hopes are high that next year earnings may grow by double digits for the first time since 2011 on the back of the rebound in energy and Trump's tax cuts. In anticipation of that, the SPDR S&P 500 ETF (SPY) is ending the year up by 12.4%
Outlook Dims For Some Sectors, Brightens For Others
Energy wasn't the only sector to see a divergence between profits and performance. Even though real estate had the strongest earnings growth this year, performance for the Real Estate Select Sector SPDR Fund (XLRE) was barely positive, at 1.8%. A spike in interest rates during the second half of the year weighed on the outlook for the interest-rate-sensitive real estate sector and cut deeply into returns for the ETF.
The interest-rate spike had the opposite effect on financials. The sector saw paltry earnings growth of 0.2% in 2016, but the Financial Select Sector SPDR Fund (XLF) was one of the best-performing sector ETFs, with a 22.3% return.
Profits for financials are expected to get a lift in the coming year thanks to the widening spread between short-term and long-term interest rates, which benefits banks and insurance companies. Financials may also benefit from less onerous regulations once the Trump administration comes to power.
The industrial and materials sectors―which saw their earnings decline in 2016―may also get a boost from Trump's policies. His infrastructure spending plan is seen as a boon for those sectors. The Industrial Select Sector SPDR Fund (XLI) and the Materials Select Sector SPDR Fund (XLB) rose by 20.4% and 17.8%, respectively, this year.
On the flip side, health care was the only sector to end 2016 in the red. Despite growing earnings by more than 6%, health care stocks fell by 2.4% as measured by the Health Care Select Sector SPDR Fund (XLV). Accusations of price gouging against drugmakers and regulatory uncertainty ahead of the new presidential administration next year pressured XLV despite the earnings bump.
Contact Sumit Roy at [email protected]