Weekly Wisdom – November 10, 2022

By Hightower Great Lakes on November 10, 2022

Energy Securing Broad Sector Gains 

Third quarter earnings have been mostly positive, despite originally low expectations. As of November 8^th, ~70% of the S&P 500 index has had positive earnings surprise and ~59% have had positive sales surprise.

It is arguably more important that earnings growth is currently at ~3.5% y/y for earnings and ~12% y/y for sales for the same period.

It was general consensus that, due to the Fed continuing to raise rates as a result of rapid inflation, earnings growth would be at a modest 1.3%.¹

If you delve into this 1.3% overall SPX earnings growth, 7 out of 11 sectors were expected to actually have negative y/y earnings growth. The two sectors that were expected to be, and are turning out to be, on complete opposite ends of the earnings spectrum are energy and technology.

First, let’s take a look at the currently booming energy industry. If you are using the XLE Sector SPDR Fund, ~82% of companies have had positive earnings surprise and ~76% have had positive sales surprise.

Growth shows an even more astounding figure, with earnings growth at ~148% y/y and sales growth at 50% y/y for Q3, thus far. Despite these growth figures, this was certainly not the trend for the sector a decade or so ago.

During the 2010s commodities were experiencing significant volatility as energy companies increased their supply, resulting in unfavorable shareholder returns.

U.S. crude production, which was around 5 mbpd at the beginning of the 2010s, shot up to a record-breaking 13 mbpd by the end of the 2010s.² Currently, U.S. crude oil production is around ~11.9 mbpd.

Front-month WTI contracts plummeted ~23% in the 2010s, and this, compounded with the negative sentiment toward traditional hydrocarbon fuels, made energy an unattractive sector for investment.

If you look at the S&P 500 versus XLE Sector SPDR Fund, the annualized return from 2010 to the end of 2019 was ~13.5% for the S&P 500 and a meager ~3% for the XLE.

This poor performance was reflected in index presence as energy only held a less-than 5% weighting in the S&P 500 at the end of 2019, compared to over 15% in 2008 and around 15% currently.

It is worth noting that a big difference between mid-2008 and now is that front-month WTI contracts were trading at around $146 at the peak in July 2008 and only traded as high as around $123 this year.

It seems now the world is realizing that the hard transition to zero-emission energy is a little less realistic than previously thought.

The catalyst here was the Russian invasion of Ukraine, which resulted in a cutoff of Russian gas to Europe.

The invasion, along with OPEC production cuts, general raw material/commodity inflation, and supply chain issues caused energy prices to rise; this translated into higher earnings for energy companies.

Some may have originally thought that the looming U.S. recession and current European recession may cause significant demand destruction for energy.

So far this is not the case and investors, as well as others, may have underestimated the inelasticity of energy demand.

Less than 30% of total oil production goes to gasoline as an end-product. 40% of oil demand goes to things like petrochemicals, industrial applications, off road vehicles like tractors or construction equipment, cooking and heating applications.

This explains why, during the pandemic, demand for oil and petroleum liquids only fell 8%.³ These statistics show that hydrocarbons have been and will continue to be essential in the near term.

This inelasticity of demand comes in stark contrast to companies in the Technology Sector SPDR Fund (XLK) and Communication Services Select Sector SPDR Fund that have respectively seen -3%, and -5.7% y/y earnings declines.

Tech In Trouble

Looking at the technology-focused XLK ETF, third quarter sales have grown 6.5% y/y, and earnings growth has declined -3%.

While sales growth remains positive for the most recent quarter, it pales in comparison to the y/y sales and earnings growth of 19.5% and 37% in the third quarter of 2021.

Further, the Communications-focused XLC ETF has seen uninspiring y/y sales growth of 1.8%, while earnings have declined -22.7%.

This same ETF saw impressive sales growth of 16% and earnings growth of 42% in the third quarter of 2021.

The performance in 2021 in both XLK (+34.74%) and XLC (+15.96%) reflects the strong sales and earnings growth witnessed during the year, while year-to-date performance in XLK (-28.25%) and XLC (-39.78%) are reflective of the stagnating sales and declining earnings growth seen in the quarter.

Weakness across technology and communication services has been driven by multiple factors, such as higher interest rates, a stronger dollar, supply chain snarls, Apple’s privacy changes and softening macroeconomic conditions.

Technology-focused companies are largely valued on their future cash flows, and for the last decade these future cash flows have been discounted at an average rate of 2.09% (United States 10 Year Treasury Yield 1/3/12 – 11/8/22), whereas that discount rate now stands at 4.12% and is expected to remain higher for longer.

These companies, whose growth has been fueled by borrowing at low interest rates, now have to borrow at a roughly 2x rate.

Moreover, the three largest weightings in XLK receive 66%, 49%, and 84% of their sales from international customers. Similarly, the three largest holdings in XLC receive ~60%, 54%, and ~60%, respectively.

Given the strength of the dollar (+11.8% YTD) these sales are now worth less when converted back into dollar terms. Notably, Apple (AAPL) is forecasting a 10% foreign exchange headwind for the quarter ending December 31^st.

Since Apple’s introduction of their app tracking transparency rules in 2021, digital advertising companies have experienced negative impacts on their ability to effectively target their user base.⁴

As a result, digital advertising companies are now dedicating billions of dollars toward artificial intelligence that will enhance advertisement targeting.

These combined factors have resulted in increased capital expenditures and decreasing advertising revenue growth. All these impacts are simultaneously occurring amid a global slowdown that caused companies to clamp down on certain expenses.

Despite the two ETFs’ poor performance YTD there are high-quality companies reaching valuation levels not seen in years.

Specifically, we remain focused on companies that offer some or all of the following characteristics: continued sales growth, solid free cash flow generation, growing market share, superior product offerings and a focus on mission-critical services.

Click here to read last week’s Weekly Wisdom (11/3).

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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¹ Source: J.P. Morgan Wealth Management (October 19^th 2022)

² Source: Reuters (December 27^th 2019)

³ Source: CNBC (September 15^th 2022)

⁴ Source: Reuters (April 24^th 2021)