Two Sectors to Buy, Two to Avoid

Earnings season unofficially started with Alcoa (NYSE: AA) back in January. And it ended last week with Wal-Mart’s (NYSE: WMT) report.

Now that it’s over, let’s take the time to check up on the two key metrics I told you to keep an eye on this quarter: The earnings “beat rate” and the guidance spread.

As I’ll show you, the final results aren’t overwhelmingly bullish. Yet there are reasons for optimism and pockets of opportunity we should be exploiting.

Falling Short of the Averages

Collectively, S&P 500 companies beat analysts’ estimates in the fourth quarter. Profits increased 8.3% versus expectations of only 5% growth. But that masks the underlying weakness experienced by individual companies, which is evident in the earnings beat rate.

You’ll recall that the earnings beat rate is simply a measure of the percentage of companies beating analysts’ expectations for profits. And this quarter, it checked in slightly below average. Only 60.4% of companies surpassed earnings estimates compared to a long-term historical average of 62%.

If we break down the results by sector, though, pockets of strength exist.

Remember, we consider a beat rate of 65% or more to be extremely bullish. As you can see, the Technology and Consumer Discretionary sectors both surpassed that threshold, with beat rates of 68.2% and 65.7%, respectively. The Telecom and Utilities sectors pulled up the rear, with abysmally low beat rates of 33.3% and 40.0%.

Key takeaway: If you’re looking to capitalize on the cheap stock prices I noted yesterday, stick to technology and consumer discretionary stocks. They possess the strongest underlying fundamentals. And avoid telecom stocks – which I warned about previously – and utilities stocks. Based on the latest earnings beat rate, they possess the weakest underlying fundamentals.

Don’t Freak About the Negatives

Moving onto the guidance spread, let’s just say it’s not exactly a positive.

Recall that the guidance spread measures the difference between the percentage of companies raising guidance and the percentage of companies lowering guidance. And it was negative for the second quarter in a row.

However, don’t interpret a negative number as being a complete disaster. Put into perspective, the figure isn’t as bad as you might think…

For instance, we’ve witnessed a negative guidance spread 15 times since 2003, or about 42% of the time. So it’s not exactly rare. And this quarter’s reading is nowhere near the all-time low (around 15%) that we hit during the throes of the financial crisis.

So there’s no reason to panic just because it’s negative.

Especially because I’m convinced that corporate executives are actually refraining from raising guidance in order to under-promise and over-deliver, which is skewing the numbers.

What makes me say that? It’s simple: The latest economic data doesn’t jive with the negative guidance spread.

From housing starts and initial jobless claims, to retail sales and the ISM Manufacturing index, the data is all improving. In fact, Bespoke Investment Group’s Economic Diffusion Index, which tracks more than 30 various economic indicators, has been gaining ground since August 2011.

The latest reading of 9 means more economic indicators are surprising to the upside than the downside. Translation: After a mid-year slump, the economy appears to be strengthening, and corporate profits are bound to follow suit.

Bottom line: The best word to describe the fourth-quarter earnings season is “mediocre.” But the latest economic indicators point to improving conditions, setting the stage for higher corporate profits – and, in turn, higher stock prices – in 2012.

Ahead of the tape,

Louis Basenese

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Earnings season unofficially started with Alcoa (NYSE: AA) back in January. And it ended last week with Wal-Mart’s (NYSE: WMT) report. Now that it’s over, let’s take the time to check up on the two key metrics I told you to keep an eye on this quarter: The earnings “beat rate” and the guidance spread....