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Investors Should "Think Small, Think Growth"

If the economy recovers in the first half of 2002, as expected, the stock market should continue to advance. And that outlook means investors should "think small, think growth." Such is the advice from Sam Stovall, senior investment strategist for Standard & Poor's.

Stovall's reasoning is that at the midpoint of recessions and beyond, the Nasdaq and the Russell 2000 index have markedly outperformed the broader measures. Stovall cautions investors not to wait for an upturn in corporate earnings to return to buying stocks -- he points out that people who did that in the 1990-91 downturn wasted up to two years of potential stock profits, because the market recovers ahead of profits.

Closer at hand, he thinks both Nasdaq and the S&P 500 may fall temporary victim to profit-taking and some technical resistance. But with a more sanguine longer-term view, he lists a number of stocks ranked buy by S&P, including Electronic Boutique Holdings, Evergreen Resources, Photronics, and Landstar System in the small-cap sector.

Stovall made these comments in a chat presented Nov. 20 by BusinessWeek Online and Standard & Poor's on America Online. Following are edited excerpts from his answers to questions from the audience and from Jack Dierdorff of BW Online. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Sam, do you see the market continuing its general upward trend? Is this rally getting ahead of itself?

A: Our opinion is that the markets are anticipating an economic recovery sometime in the first half of next year, and as a result, we're seeing strength in small-cap stocks, growth stocks, and economically sensitive areas. Near-term, however, both the Nasdaq and the S&P are running into technical resistance that will require a few attempts to break. So, in a nutshell, near-term I see some profit-taking and a few attempts at breaking through resistance, but longer-term, should the economy recover on time, the market is likely to continue to advance.

Q: I'm here to find out what stocks are hot and what to buy in the medium-price range. A few suggestions?

A: S&P covers about 1,100 stocks in our STARS (Stock Appreciation Ranking System), and 5-STAR stocks are our best-buy recommendations, where we think these shares will outperform the market in the coming 6 to 12 months.... A few of the small-cap stocks that we favor include Electronic Boutique Holdings (ELBO), Evergreen Resources (EVG), Photronics (PLAB), and Landstar System (LSTR).

Q: What is your outlook for tech stocks in this environment? For example, EMC?

A: We have a "market weight" recommendation on the tech stocks, which is another way of saying we're neutral on the group. The S&P tech sector is down around 25% this year on top of the near-40% decline last year. Our feeling is, however, that if we have not reached bottom, we are very, very close to the bottom, and therefore think it's worth having a normal exposure to this sector. EMC is currently ranked 3-STAR, or hold. A few of the 5-STAR companies include NVIDIA Corp. (NVDA), Symantec (SYMC), and Barra Inc. (BARZ). In general, most of the companies on our "buy" list are either software or semiconductor companies.

Q: What are the best-looking REITs at this time?

A: We currently have two companies in the REIT category that carry 5-STAR rankings: Boston Properties (BXP) and TrizecHahn Corp. (TZH). In general, however, we are still positive on the group because of consumer demand and lower interest rates.

Q: Consumers are spending again -- your feelings on HD

[Home Depot]?

A: We like Home Depot -- it's currently ranked 5-STARS, and we see earnings rising over the next several years. We have an estimate of $1.25 [per share] for fiscal 2002 and $1.50 for fiscal 2003. The company's projected five-year earnings growth rate is 20%, and it carries an S&P earnings and dividend rating (based on historical earnings and dividend growth) of A+, which is tops.

Q: Why have pharmaceuticals like Merck (MRK), etc., not performed better?

A: The pharmaceuticals have been under the cloud of patent expirations over the past year or so, since in the coming few years many of their high-profile drugs will lose patent protection and therefore could adversely affect earnings growth. However, it does not mean that you should ignore these stocks altogether. The three 5-STAR stocks in this group are Johnson & Johnson (JNJ), Merck (MRK), and Pfizer (PFE).

Q: Coming out of a recession, which asset classes have historically outperformed (large-cap or small, growth or value)?

A: Good question! Going back to 1960, and looking at market performances 6 and 12 months after the market has bottomed, typically midway through a recession growth beats value and small-caps beat large-caps. In particular, the average gain for the S&P 500 12 months after its bottom has been an average of 32%, vs. 29% for the value component and 36% for the growth component. During the same time frame, the Nasdaq has advanced an average of 55%, while the Russell 2000 has gained an average of 66%. So in other words: think small, think growth.

Q: How will telecommunications stocks perform within the next year or so?

A: We currently have a market-weight recommendation on the telecom services sector. (That sector does not include the telecom equipment manufacturers.) We are most favorable on wireless and on selected local telephone stocks, yet not optimistic on long-distance companies. We have three stocks in this sector ranked buy. The first is Alltel (AT); the second is PCS

, which is Sprint's PCS group -- and that's it because I just realized that we downgraded BellSouth (BLS) on Nov. 15 to 4-STARS from 5-STARS.

Q: Opinion on financial services, specifically large banks?

A: We currently have a market weight or neutral recommendation on the financials because we believe that lower interest rates and a reviving economy may be offset by credit-quality concerns. However, take heart from the fact that financial stocks in general tend to outperform the market 6 and 12 months after market bottoms during recessions. Favorite stocks in this category currently include FleetBoston Financial (FBF), J.P. Morgan Chase (JPM), and PNC Financial Services (PNC). Those are all rated 5-STARS or buy.

Q: I have no faith in the market. Profits, profits, profits -- when will we see them?

A: Profits are something that we are likely to see again in 2002, but I wouldn't wait for them to reemerge before investing again in equities. Earnings are typically a lagging indicator. In March, 1991, the most recent recession ended, and the stock market anticipated this recession's end by five months (it bottomed in October, 1990). Yet the change in year-over-year operating earnings for the S&P 500 did not become positive again until September, 1992, so you would have waited almost two years waiting for a confirmation signal and would thus have missed out on the majority of the market's advance. We see earnings falling 27% for the S&P 500 in 2001, yet advancing 34% in 2002.

Q: Is the Nasdaq in a bear-market rally? The downtrend has not broken yet.

A: That certainly is a good question. The Nasdaq is now retesting the levels established back in April of this year. And resistance begins at 1923 and extends all the way up to 2328. Our technical analyst, Mark Arbeter, believes that a pullback or pause in the rally is expected, since it has come so far since Sept. 21. He believes that it is in an overbought condition in the short term. I think time will tell, however, if Sept. 21 was the beginning of a new bull market or simply a rally in a bear market.

Q: The relative strength of the gold sector seems to have improved over the past year. What do you think of gold stocks?

A: In general, we're favorable on gold stocks. None is ranked 5-STAR. However, Barrick Gold (ABX) and Newmont Mining (NEM) are ranked 4-STARS, or accumulate.

Q: A timely question, with energy prices down -- what's your outlook for the integrated oils and drillers? Is it time to buy?

A: We have a few of these ranked buy. On the integrated side, both ExxonMobil (XOM) and ChevronTexaco (CVX) are ranked buy. On the drilling side, we have several ranked accumulate. These include BJ Services (BJS), Nabors Industries (NBR), and Noble Drilling (NE). Despite the prospect of an oil-price war, we still think this sector should carry a market weighting because of the potential for a cut in oil production by OPEC, as well as supply disruptions.


[Microsoft] a buy at today's price?

A: Microsoft is currently ranked 4-STARS -- so you're close, but you don't get the cigar! We see the Xbox as a long-term investment that will continue to diversify the company's revenue stream. So in general, we're favorable on the outlook -- we're just not willing to bet our bonus on the outlook.

Q: The feds put money into the market after 9/11 -- do they take it out now that the markets have had a rally?

A: The Fed certainly has been adding liquidity to the market for quite some time, and there certainly is the possiblity that they will hold off in adding liquidity until they see additional economic reports. Yet the Fed remains prepared to assist the economy in recovering during the first half of 2002.

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