Sector Rotation & Q3 Earnings

As we launch into the Q3 Earnings season, this article takes a look at expectations, sector strengths and positioning

Q3 Earnings season is already underway and about to shift into high gear. Lets take a look at the setup for Q3 and expectations for S&P 500. I have called out the excellent Refinitiv dashboard as my go-to for the earnings season.

Quoting from Refinitiv “Full-year growth expectations for 2023 are currently 2.3%, the lowest since 2020 and below the long-term average of 7.8%.  Q3 is also expected to be a small contributor to the full-year growth rate with a forecast y/y growth rate of 1.3%.  Instead, the bulk of growth expectations are expected in Q4 with a growth rate of 10.8%.” 

For Q3, let's look at expected sector contributions to earnings growth 

As I have been calling out, Communication Services sector leads with most earnings growth and energy has negative growth expectations. From a guidance perspective, we have seen 79 negative Q3 EPS pre-announcements compared to 41 positives. In Q2, we saw 62 negative pre-announcements compared to 39 positive heading into earnings season. 

Better than expected earnings from Banks and economic data was overshadowed by worsening geopolitical situation on multiple fronts. In this context, we are expecting some broad themes to work

• Financials are beaten down and expectations are very low. As we have already see from JPM, C, WFC, they are not seeing the worst case scenarios play out and this could be enough to start a recovery in the sector. There are still likely a lot of landmines in the smaller banks so we have to be very selective.  We like JPM, MS. Goldman is finally out of Greensky and a flush on earnings would be a good opportunity to enter.

• Energy Sector will continue to outperform given very low expectations for Q3.  We like our positions in the Oil Majors.

• Communication Services while expectations are high, should be able to beat and guide up given the Online Ad spend is improving smartly. This should benefit GOOGL and META.

• Consumer Discretionary is likely mixed.  AMZN is out of their last spend cycle and their retail margin should improve. Advertising business should benefit from the trends mentioned above. AWS has underperformed the other cloud providers so expectations are pretty low. Rest of the sector will likely underwhelm

• Technology is going to be very interesting.

  • AI buildout will keep NVDA outperforming and a new product cycle could help AMD's Data Center business if they can ship in volume early in Q4. Don't expect too many other stand-outs in Semis. Healthy backlog should help Semi Caps buffer the impact of any downturn.

  • Cybersecurity spend is still robust and a spate of incidents will ensure that budgets are not cut.  Consolidation is underway and will speed up dramatically going forward

  • Cloud/SaaS companies are again a mixed bag. We are concentrating on companies that beat and guided up in Q2. M&A story is also in play in Cloud/SaaS space and we expect smaller players with significant ARR and high growth to be acquired by larger players.

  • While we are very bullish on the AI story, we believe that the revenue ramp  for AI Software/Tools/ Functionality is going to be slower than expected. We believe that the big jump occurs in 2024 H2 and takes off from there.

• Healthcare: There is only one story here GLP-1 and everyone else is defending status quo. NVO and LLY continue to be runaway winners. We don't believe the impact of GLP 1 is so negative (in the immediate future) that it justifies the haircut we have seen in Med Devices & Renal Care.

• Industrials: Aerospace & Defense has woken up from terrible underperformance all year. The healthy book to bill ratios will help.  However there are headwinds with the unsettled budgets and debt limits. We like NOC especially with the B21 first flight likely before year end. Commercial side is still a mess with quality issues at Raytheon (P&W) and Boeing/Spirit Aero. We are looking for a flush on earnings from RTX. We will be buyers on a major selloff.  Technology suppliers to Defense will continue to outperform. The Federal and DoD technology and Cybersecurity budget is growing and our picks have domain knowledge and security clearance moat that is not overcome easily. We continue to like BAH, CACI and SAIC

• Materials: China is buying Iron Ore again and has talked about new contract negotiations with producers.  We don't see other green shoots in this sectors that are sustainable. Interest in acquiring US Steel is the most interesting story in the sector

• Utilities and Staples continue to underperform and we believe there are better opportunities in other sectors.

• We are also not touching Real Estate with the interest rates this high and no likelihood of cuts any time soon.

The stocks and sectors mentioned here are what we like for our portfolios and our investment and risk profile. We have positions in the tickers mentioned in the article.

We are not recommending any of these stocks to the readers. You will need to conduct your own due diligence and consult a registered financial advisor before you invest. 

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