A year ago, the booming resource sectors were putting the wind in the sails of stock market earnings. Now, they've become the anchor pulling profits underwater.
S&P Capital IQ, the equity research arm of Standard & Poor's, said the consensus of earnings forecasts from Wall Street analysts now point to a year-over-year earnings decline of 0.3 per cent in the second quarter, which ends in just a few weeks. If this expectation holds, it would be the first quarterly earnings decline since the 2009 third quarter – when the markets were still in the grip of a global recession.
The main culprits are the energy and materials sectors, where slumping commodity prices and disquieting economic signs from China, Europe and the United States are pushing analysts to slash their earnings expectations. Capital IQ projects that the materials group is on track for a 10.6-per-cent year-over-year earnings decline in the quarter, while energy profits are poised to fall 6.7 per cent.
The trend could deal an even bigger earnings blow to the resource-heavy Canadian stock market – where the energy and materials sectors account for fully 45 per cent of the benchmark S&P/TSX composite index, compared with less than 15 per cent of the S&P 500.
"I can see weakness in the same areas [in Canada]," said S&P Capital IQ earnings analyst Christine Short.
She said 80 per cent of the Canadian energy companies that her firm tracks are forecast to post earnings decreases in the second quarter, while more than half of the Canadian materials companies are expected to show a drop. For many companies, analysts forecast double-digit percentage declines.
The slumping earnings prospects represent a dramatic change of fortune for the resource sectors, which a year ago were the biggest drivers of earnings growth in the stock market. In the second quarter of 2011, the materials group posted year-over-year earnings growth of more than 50 per cent, while energy profit surged nearly 40 per cent.
Some analysts argue that the pullback from last year's strong results still leaves the resource profits at relatively high levels on a historical basis. They also say that the recent market declines have driven stock prices down even faster than the earnings expectations have fallen, leaving equities in general – and the resource stocks in particular – looking inexpensive based on price-to-earnings (P/E) ratios, a favourite yardstick for stock valuation. S&P 500 energy and materials sectors are both trading well below their historical P/E averages.
But with prices for most major commodities still deteriorating, those sectors look not so much like good values as "value traps" for investors, argues Savita Subramanian, head of U.S. equity and quantitative strategy at Merrill Lynch.
Value traps, Ms. Subramanian said, are sectors that appear inexpensive on a P/E basis, but where price and earnings momentum are still headed downward. Energy and mining stocks fit the bill.
In a report this week, she said these sectors "are cheap only because relative prices are falling faster than relative earnings expectations are being marked down." As a result, she said, such value traps typically continue to underperform the broader market despite their apparent cheap valuations.
"Sixty-seven per cent of the time, these industries either remain value traps, or their deteriorating fundamentals cancel out their undervaluation altogether and they fall even further."
S&P's Ms. Short agreed that equity analysts are still playing catch-up to the pessimism that has already been priced into the market.
"Consensus estimates do tend to lag. [Analysts] really need confirming data," Ms. Short said. "I do think in some cases analysts' estimates are just too high."