Hickey: Past Shows Lower Earnings Expectations Boost Stocks

April 14, 2015

Paul Hickey is co-founder of Bespoke Investment Group and Bespoke Market Intelligence. Bespoke provides research and advisory services to institutional and individual investors. The firm's research is among the most sought after and respected in the investment community. Hickey is frequently seen on CNBC, Bloomberg and CNN, and the firm's analysis is often cited by publications such as the Wall Street Journal, Barron's and the New York Times.

Hickey recently sat down with ETF.com to discuss the upcoming U.S. earnings season and what the current wave of negative revisions to corporate profit forecasts means for stock returns ahead. He shares his views on the U.S. economy, the level of interest rates and future direction of the dollar.

ETF.com: Let's get started with the corporate earnings season, which kicks off officially with Alcoa today [April 8]. Tell us what you expect from it.
Paul Hickey: Just for starters, expectations have come down significantly for the market and for all 10 individual sectors. While everyone focuses on energy, in reality, analysts have been cutting their estimates across the board. Analysts are expecting profits to decline for the first time since the third quarter of 2012. It is the biggest decline since 2009.

The results aren't going to be good. But everyone is well aware of that. What is more important is how the market is going to react when actual earnings announcements start rolling in, given that the bar has been set so low.

We looked back at prior quarters where analysts had been cutting estimates on more companies than they've been raising estimates for leading into earnings season. What we found is that when the number of cuts exceeds positive revisions, the S&P 500 gains an average of about 2.4 percent during earnings season. And it shows positive returns more than 80 percent of the time. Conversely, when you see positive revision exceeding negative revision, the S&P's average return has actually declined 1.2 percent, with positive returns only 40 percent of the time.

There's a clear-cut trend where low expectations on the part of analysts has translated into positive returns for the market. Like I was saying earlier, coming into earnings season, the negative revisions outnumber positive revisions by more than 2-to-1. In the S&P 1500— which comprises the large, mid- and small-cap stocks—there's been about 700 negative revisions in the last month, and 300 stocks have seen positive revisions.

Even if you took energy out, the ratio would still be close to 2-to-1 negative. There have been only three quarters in the last six years where we saw a more negative revision spread. And in each of those three earnings seasons, the S&P 500 gained between 4 percent and 5.5 percent.

These trends also hold true at the individual sector level. Especially from an ETF perspective, there are some sector funds that we find interesting right now, given this trend. One of them is the Industrial Select SPDR (XLI | A-91), which represents the industrial sector. The revisions ratio in that sector has only been this low heading into an earnings season three other times in the last six years. And in each of those periods, the industrial sector was up 5.3 to 9.4 percent in the ensuing six-week period of earnings season.

The industrials are made up of large multinationals, so the results probably aren't going to be great—impacted by the strong dollar and relatively weak economic data. But again: "Tell us something we don't know." Everybody is well aware of this and it's priced into the market.

ETF.com: Are there any other sectors where the sentiment is so negative that chances are they will actually outperform?
Hickey: Consumer staples is another sector where the revisions ratio hasn't been this low since about 2009. Sentiment is very negative, again because of the large multinational companies there. When the bar is set that low, it's easy to surpass it.

ETF.com: Let's take our discussion beyond the immediate horizon and this earnings season. We've had some analysts here on Alpha Think Tank like Ed Yardeni, who think the U.S. is in a secular bull market that will continue for a few more years. On the other hand, we've had others like Axel Merk pointing out that the dollar rising in tandem with the stock market is a sign the bull market is approaching its end and investors should be cautious. What is your view?
Hickey: The fact that the dollar is rising shouldn't be considered a negative fact here. Dollar trends tend to be measured in years rather than months or quarters. The dollar's rally is usually a multiyear process. We think we're probably in the midstage of it. The dollar bottomed in 2009 and it really didn't get going until the second half of last year.

During the '90s, we had a strong dollar and equities did well. During the 2000s, we had a weak dollar, and U.S. equities underperformed. Right now we're in a decade where we're going to see a stronger dollar. But just because both the dollar and stocks are rallying isn't necessarily a red flag, in our view. Historically speaking, when you have a strong dollar, U.S. equities show more strength than during periods when the dollar is weak.

ETF.com: So your view is that this earnings weakness is a temporary blip and the U.S. economic expansion will continue for a while still?
Hickey: Yes, I think so. The market is going to be dependent on the Fed. When the window for the Fed to raise interest rates gets pushed further out, equities do well. When the market starts to anticipate the Fed hiking earlier, we run into trouble. So as we get closer to the period where the Fed lifts off, we're going to see some volatility in the market. But I don't think it's going to set the stage for the end of the bull market or the end of the economic expansion.

ETF.com: Speaking of interest rates, a lot of people are concerned about their exceptionally low level on an absolute basis and that a potential return to the historic average would have a very negative effect on both bonds and stocks. At the same time we've had analysts here, like David Kotok, who expect U.S. interest rates to continue going down because of what's going on in the rest of the world. Give us your thoughts on this.
Hickey: Yes, people have been calling for the increase in rates for years now, and it just doesn't seem to come. Throughout this year, we don't see interest rates, rising much at all, if any. The bond buying from the ECB is going to keep a weight on rates over in Europe. And that in turn will help keep an anchor on rates here.

For most of this year, I don't see interest rates spiking from where they currently are. While I may not necessarily want to be long Treasurys, I definitely wouldn't short them either. As far as the stock market is concerned, where valuation is dependent on earnings and the general level of interest rates, I don't see a sudden rise in rates as becoming a major roadblock for equities.

ETF.com: Thanks for your time.

Industrial Select SPDR (XLI | A-91)

Hickey likes XLI and the industrial sector in general, thinking that earnings revisions have been revised downward to the point where they've overshot the mark—and that surprise to the upside may occur. He cites XLI by name, and why not? The fund leads the U.S. industrials segment in assets and dominates in liquidity, while delivering a basket that represents the segment well. Hickey notes that huge multinationals dominate the portfolio, and that's certainly true in the case of XLI. The ETF pulls from the S&P 500 rather than the full universe of U.S. stocks, so large-caps get an extra boost. Still, XLI's allocation to leader General Electric aligns with—rather than exceeds—competing cap-weighted ETFs. Note too that GE itself is becoming more "pure-play" industrials as it spins off financing operations.

Vanguard Consumer Staples (VDC | A-95)

Another sector that has been hit hard by negative analyst sentiment recently is consumer staples. The earnings weakness caused by the dollar's strength in the large multinational companies that make up the sector is already baked into their stock prices. In Hickey's view, when the bar is set that low, it won't be hard for these companies to surpass earnings expectations and provide a reason for investors to bid up their shares again. VDC is our "Analyst Pick" for this sector. The fund delivers pure-play consumer staples exposure for a mere 12 bps annual fee. VDC tracks its index extremely well and has sufficient liquidity for large as well as retail investors.

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Methodology: ETF selections are made solely by ETF.com. They are neither selected by, nor are they investment recommendations from, Alpha Think Tank strategists. ETF selections are made by the ETF.com Analytics team based on the themes highlighted in each weekly interview with Alpha Think Tank strategists.

We implement a stop-loss of 10% from the ETF.com Pick Date, whereby any funds triggered by that stop will drop off the tracker. The tracker data is updated weekly and is subject to change, according to our ongoing interviews with our strategists.

Ticker Fund Name ETF.com Pick Date TR % (Since Pick Date) TR % (1 Yr) Closing Price $ (4/10/15) Inspired By
MCHI iShares MSCI China 15/04/2014 42.66 37.56 62.25 Faber
GXC SPDR S&P China 03/02/2014 41.78 32.57 96.44 Rogers
INDA iShares MSCI India 24/02/2014 38.78 26.96 33.33 Roubini
DBJP Deutsche X-trackers MSCI Japan Hedged Equity ETF 12/06/2014 30.46 41.68 42.62 Roubini
DBGR Deutsche X-trackers MSCI Germany Hedged Equity ETF 24/02/2014 25.92 30.91 29.80 Roubini
GXC SPDR S&P China 08/10/2014 24.17 32.57 96.44 Merk
INDA iShares MSCI India 09/04/2014 23.87 26.96 33.33 Kotok
HEDJ WisdomTree Europe Hedged Equity 12/01/2015 23.69 28.87 68.52 Kotok
VHT Vanguard Health Care 02/07/2014 22.44 35.90 137.97 Yardeni
GMF SPDR S&P Emerging Asia Pacific 09/04/2014 21.21 22.08 94.44 Kotok
NKY Maxis Nikkei 225 03/02/2014 20.91 21.94 19.81 Rogers
MCHI iShares MSCI China 16/03/2015 20.10 37.56 62.25 Yardeni
XTN SPDR S&P Transportation 15/10/2014 19.79 23.16 103.45 Kotok
EWH iShares MSCI Hong Kong 15/04/2014 19.67 19.27 24.06 Faber
HEDJ WisdomTree Europe Hedged Equity 03/12/2014 19.45 28.87 68.52 Fitzsimmons
DXJ WisdomTree Japan Hedged Equity 12/01/2015 18.28 40.98 56.74 Kotok
USDU WisdomTree Bloomberg US Dollar Bullish 15/04/2014 17.49 18.30 28.68 Faber
EWJ iShares MSCI Japan 03/03/2014 15.57 20.90 12.94 Friedman
ITA iShares U.S. Aerospace & Defense 05/05/2014 15.35 20.91 125.41 Bremmer
VTI Vanguard Total Stock Market 28/04/2014 14.98 16.79 109.12 Luskin
RSP Guggenheim S&P 500 Equal Weight 10/03/2014 14.37 16.85 82.34 Dorsey
DBJP Deutsche X-trackers MSCI Japan Hedged Equity ETF 18/11/2014 13.29 41.68 42.62 Luskin
USDU WisdomTree Bloomberg US Dollar Bullish 23/09/2014 13.20 18.30 28.68 Yardeni
TAO Guggenheim China Real Estate 12/08/2014 12.24 22.50 24.01 Faber
USDU WisdomTree Bloomberg US Dollar Bullish 29/09/2014 11.89 18.30 28.68 Roubini
IYT iShares Transportation Average 15/10/2014 10.96 19.35 157.11 Kotok
XLU Utilities Select SPDR 09/04/2014 10.31 10.73 44.66 Kotok
BAB PowerShares Build America Bond 09/04/2014 10.21 9.64 30.28 Kotok
BKF iShares MSCI BRIC 22/05/2014 9.89 12.85 40.60 Arnott
VTI Vanguard Total Stock Market 10/06/2014 9.69 16.79 109.12 Friedman
INDA iShares MSCI India 23/07/2014 9.41 26.96 33.33 Bremmer
VTI Vanguard Total Stock Market 24/10/2014 8.96 16.79 109.12 Bremmer
HEWG iShares Currency Hedged MSCI Germany 03/03/2015 8.86 N/A 29.61 Fitzsimmons
PXH PowerShares FTSE RAFI Emerging Markets 17/02/2014 7.17 1.13 20.02 Arnott
ITB iShares U.S. Home Construction 04/02/2015 7.11 18.78 28.20 Luskin
IEMG iShares Core MSCI Emerging Markets 28/04/2014 7.03 5.49 51.63 Luskin
IYY iShares Dow Jones U.S. 03/09/2014 6.43 16.63 106.32 Dorsey
VIS Vanguard Industrials 02/07/2014 6.14 12.56 109.35 Yardeni
FNDX Schwab Fundamental U.S. Large Company 23/09/2014 5.28 13.45 30.45 Yardeni
INDA iShares MSCI India 08/09/2014 4.98 26.96 33.33 Fitzsimmons
AIRR First Trust RBA American Industrial Renaissance 23/02/2015 4.98 -0.11 18.96 Bernstein
INDA iShares MSCI India 18/11/2014 4.69 26.96 33.33 Luskin
MUB iShares National AMT-Free Muni Bond 16/07/2014 3.61 5.30 110.18 Kotok
SGOL ETFS Physical Swiss Gold 04/11/2014 3.40 -8.67 118.26 Faber
SIVR ETFS Physical Silver 04/11/2014 2.70 -18.05 16.21 Faber
EWW iShares MSCI Mexico Capped 20/01/2015 2.40 -5.03 59.75 Bremmer
EPI WisdomTree India Earnings 03/09/2014 2.38 25.20 23.77 Dorsey
AMU ETRACS Alerian MLP ETN 27/01/2014 1.66 -2.49 27.59 Luskin
EWW iShares MSCI Mexico Capped 03/03/2014 1.65 -5.03 59.75 Friedman
FXH First Trust Health Care AlphaDEX 16/03/2015 1.46 40.14 68.04 Yardeni
SCPB SPDR Barclays Short Term Corporate Bond 17/03/2014 1.35 1.06 30.74 Yardeni
EIDO iShares MSCI Indonesia 12/02/2015 1.09 2.99 27.86 Dorsey
HYD Market Vectors High-Yield Municipal 23/02/2015 0.77 10.61 31.20 Bernstein
ROBO Robo-Stox Global Robotics and Automation 03/03/2014 0.60 3.12 27.04 Friedman
TLT iShares 20+ Year Treasury Bond 12/02/2015 0.48 21.34 129.62 Dorsey
EWY iShares MSCI South Korea Capped 24/02/2014 0.14 -4.87 59.60 Roubini
EIDO iShares MSCI Indonesia 28/05/2014 -0.18 2.99 27.86 Fitzsimmons
EWS iShares MSCI Singapore 05/05/2014 -0.79 1.59 13.06 Bremmer
XHB SPDR S&P Homebuilders 31/03/2015 -0.98 16.25 36.5 Kotok
VGK Vanguard FTSE Europe 19/08/2014 -1.14 -1.60 55.89 Luskin
XLF Financial Select SPDR 16/03/2015 -1.18 14.44 24.24 Yardeni
XTN SPDR S&P Transportation 08/01/2015 -1.78 23.16 103.45 Yardeni
IXC iShares Global Energy 18/02/2015 -1.92 -12.85 37.35 Faber
IYT iShares Transportation Average 08/01/2015 -1.96 19.35 157.11 Yardeni
GULF WisdomTree Middle East Dividend 10/03/2014 -2.59 -10.18 20.55 Dorsey
DBB PowerShares DB Base Metals 08/05/2014 -3.27 -5.11 15.40 Gartman
FXS CurrencyShares Swedish Krona Trust 23/03/2015 -3.78 -26.23 112.3 Merk
EIDO iShares MSCI Indonesia 23/07/2014 -4.60 2.99 27.86 Bremmer
ELD WisdomTree Emerging Markets Local Debt 17/02/2014 -5.23 -8.85 40.62 Arnott
IAU iShares Gold Trust 27/01/2015 -6.78 -8.61 11.68 Merk
AUNZ WisdomTree Australia & New Zealand Debt 22/10/2014 -6.80 -10.00 18.27 Gartman

As of 4/10/15


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