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How to play Alcoa's earnings

The unofficial start of corporate earnings season kicks off on Monday when Alcoa, the largest U.S. producer of aluminum, reports after the bell

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The unofficial start of corporate earnings season kicks off on Monday when Alcoa, the largest U.S. producer of aluminum, reports after the bell.

Its results follow on the heels of dimming analyst expectations across the stock market. On Sept. 30, analysts projected that fourth-quarter earnings at companies in the Standard & Poor’s 500 index would grow 14.1 percent, according to Bespoke Investments. By Jan. 3, the growth estimate had fallen to just 6.2 percent.

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Investors will be looking at earnings growth for Alcoa and other companies in the S&P 500 in light of a stagnant U.S. economy, a likely recession in Europe and signs that emerging market economies are slowing. Alcoa’s ability to meet much-lowered estimates may not be enough to spark a rally that carries over the three weeks of earnings season.

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Will companies be rewarded for jumping over a lowered bar? No matter what the results, earnings season tends to usher in volatile trading days. Here’s a look at how to play the first earnings season of 2012:

Alcoa isn’t getting much love on Wall Street lately.

Alcoa’s share price sank 50 percent from the 52-week high it reached last April when the global economy seemed to be picking up speed. It fell another 2.1 percent Friday to close at $9.16.

More than half of the analysts following the company have a hold recommendation or lower. The company announced on Thursday that it will close plants in Tennessee and cut production in Texas as part of cost-cutting moves that will lead to up to $165 million in after-tax charges, or 16 cents per share.

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Because of aluminum’s role in cyclical industries like automobile production, aerospace and packaging, Alcoa’s earnings are often viewed as a measure of broader economic growth. But that bellwether role may be diminished.

While Alcoa is the world’s second-largest aluminum company behind Rusal, according to company and industry data, increased competition from Chinese producers is leading the company to restructure its business in ways that give investors little insight into future worldwide growth, analysts said.

“There’s just no way that what happens in China won’t continue to impact the market for Alcoa,” said Charles Bradford, an analyst at Bradford Research in New York.

But China could also come to the company’s aid.

“Economy activity worldwide should get a boost as more stimulus comes from central banks, particularly in China,” said Lloyd O’Carroll, an analyst at Davenport & Company. “As this becomes evident, investors’ sentiment for (aluminum) should turn from negative early in the year to a positive.”

That would make Alcoa a value play for the patient. The company’s shares are down 6 percent over the last month, and are currently trading at close to a 52-week price to earnings low of 9.9. It pays a dividend of 1.3 percent.

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The SPDR S&P Metals and Mining ETF (XME) is a broader metals option which could gain if global economic activity picks up. Its largest holdings are Steel Dynamics, Reliance Steel and Aluminum and United States Steel.

The days when the S&P 500 was only a reflection of the U.S. economy are over. Europe and emerging market countries like China and Brazil now account for over 40 percent of revenues for companies in the index, according to research from Bank of America Merrill Lynch.

The Brazilian economy – the largest in South America – was stagnant in the third quarter, the first time since 2009 that the economy’s growth rate did not accelerate over a three-month time. The rate of expansion in China looks to be dampening as well.

That will likely mean that industrials and materials companies will fall short of even reduced earnings estimates, said Barry Knapp, head of U.S. equity strategy at Barclay’s.

“These big, multi-line industrial companies have benefited from strong margins and strong growth in emerging markets for a number of years, but that is a world that has clearly slowed a lot,” he said.

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Knapp said that technology companies could outperform over the next quarter because of continued business spending and the strength of upper-income consumers.

“This is far and away the cheapest cyclical sector,” given the likelihood of dividend increases, he said. The technology sector of the S&P index trades at a P/E of 14.4, compared with an 16.7 P/E for consumer discretionary stocks and 15.1 for industrials.

The Technology Select Sector SPDR (XLK) is one ETF option. The fund tracks the technology sector of the S&P 500 and has a more balanced orientation than other growth-focused technology ETFs like the PowerShares QQQ.

While Apple accounts for around 15 percent of assets in both funds, the XLK rounds out its top holdings with International Business Machines and Hewlett-Packard. The QQQ, meanwhile, has a higher weighting in Amazon.com and eBay.

Bill Stone, chief investment strategist at PNC, is tilting his portfolio toward dividend-paying stocks until Europe’s lingering debt crisis stabilizes.

“Once it’s clear that things aren’t going to fall apart, then stocks will do fairly well,” he said. He’s pulling back from utilities, however, because recent share gains make them look expensive.

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Vanguard’s Dividend Appreciation Fund (VIG) is one ETF option. Its top holdings include McDonald’s, IBM and Coca-Cola Co.

One smart way to play earnings season for investors who have a longer horizon may be simply buying the broad S&P 500 index. That’s because stocks remain historically cheap on a price to earnings basis.

Bob Doll, chief equity strategist at BlackRock, expects corporate earnings to rise 6 percent over 2012. That, in turn, will lead to double-digit returns for the S&P 500 as price to earnings multiples rise modestly for the first time since the Great Recession. Investors will be willing to pay more for corporate earnings because of continued job growth, low interest rates and increased business confidence, he said.

What investors pay for earnings is one of the main factors of long-term returns. Investors who bought the S&P 500 at its current P/E of 14 saw subsequent annualized 10-year returns of 15 percent, according to research from Bank of America. Investors who bought P/Es of 20, meanwhile, saw their returns narrow to only 7 percent.

© Thomson Reuters

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