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S&P's Bullish Take on 2002

The stock market will be up 10% by the middle of 2002 -- and 15% by yearend -- according to the prediction from Standard & Poor's Investment Policy Committee. Kenneth A. Shea, vice-president and director of Standard & Poor's Equity Research & Services, reports that S&P thinks this improvement will stem from the economic recovery and an earnings rebound.

The categories that will revive soonest, Shea adds, are telecommunications services, consumer discretionary, and health care. That leads S&P to recommend stocks such as Sprint PCS, Nextel, H&R Block, Home Depot, Amgen, and Biomet. But S&P's bullishness is increasing on tech stocks generally, especially for companies in semiconductors, software, and outsource manufacturing. That leads Shea to point to such names as NVIDIA, DoubleClick, and Flextronics International.

Despite the questions about the strength of this year's holiday shopping, S&P recommends retailers Wal-Mart, Michaels Stores, and Ann Taylor, Shea says. But Gap is listed as a stock to sell. And in another industry, Enron is an avoid, for obvious reasons.

Shea made these remarks in a chat presented Dec. 18 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: The Dow Jones average flirted with 10,000 again today. Do you see the rally regaining its strength?

A: Yes, I do. The S&P Investment Policy Committee believes that the anticipated economic recovery in 2002 will fuel the earnings rebound that is widely anticipated among investors. The IPC forecasts a close for the S&P 500 index on June 30, 2002, of 1,255, up about 10% from its current levels. And the IPC sees 1,315 at the end of 2002, up 15% from current levels. These approximate gains translate to similar expected averages for the Dow Jones industrial average.

Q: When do you see that earnings turnaround starting? And where should we look first for the revival?

A: Good questions. S&P analysts look for a 10% year-to-year increase in first-quarter '02 earnings for the S&P 500, led by the telecommunications-services, consumer-discretionary, and health-care sectors.

Q: Interesting mix -- telecom services has been down, for example, but health care has done fairly well.

A: Year-to-date, the best-performing sectors have been basic materials, consumer discretionary, and consumer staples. The worst sector performances, year-to-date, have been information technology, utilities, and energy. In light of the S&P 500's 14% decline year-to-date, the 15% decline in the telecommunications sector has underperformed, but not by a significant magnitude.

S&P analysts believe the telecommunications sector is poised to improve as investors recognize the substantial opportunity that increased long-term demand for wireless communications. Many of these companies have either merged or become stronger operationally, providing a fertile area for rebound. S&P's favorites in this sector include Sprint PCS (PCS) and Nextel Communications (NXTL).

In the consumer-discretionary sector, while the sector is down about 5% year-to-date, we see continued outperformance ahead, led by the commercial services industry -- H&R Block (HRB), ChoicePoint (CPS), and Apollo Group (APOL) -- and home-improvement retailers Home Depot (HD) and Lowe's (LOW).

The health-care sector, which is down about 14% year-to-date, is viewed as an outperformer next year. That's fueled by anticipated strong performance for biotech companies and, to a lesser extent, medical-device companies. Our favorite biotech stocks at the moment include: Amgen (AMGN), Cephalon (CEPH), Genzyme General (GENZ), and Idec Pharmaceuticals (IDPH). Our favorite medical-device companies include Johnson & Johnson (JNJ), Biomet (BMET), and St. Jude Medical (STJ).

Q: What's your outlook for tech stocks generally? Any other tech areas besides telecom services to consider?

A: S&P's technology analysts have been increasingly bullish on the sector, particularly for semiconductors, certain software companies, and outsource manufacturers. In the semiconductor area, S&P believes that the industry is near a cyclical trough. S&P looks for a modest recovery for this volatile industry next year, with an even more solid recovery in 2003 and 2004.

Our favorites in this industry are Fairchild Semiconductor (FCS), Linear Technology (LLTC), Microchip Technology (MCHO), and NVidia (NVDA). In the software area, S&P analysts like Siebel Systems (SEBL) and DoubleClick (DCLK). With the contract manufacturers, S&P's favorite is Flextronics International (FLEX).

Q: NVDA has had a great run. What's your ranking right now?

A: The S&P semiconductor analyst currently ranks NVidia 5-STAR (strong buy). Microsoft's (MSFT) success with the Xbox video-game console is fueling the demand for NVidia's chips, which are embedded into the system. This recent addition to the S&P 500 index is still worth accumulating, despite its recent runup, as its strong position in the booming video-game industry should lead to superior growth prospects in the near future.

Q: It seems to be a drab Christmas shopping season -- how is this affecting stocks of retailers?

A: The relatively weak retail sales numbers in November were due in large part to an unseasonably warm autumn. The same-store sales at discounters were generally better than those of department stores, as many consumers shunned apparel. S&P believes that the current high level of promotions and markdowns will likely erode profits of many retailers in the fourth quarter.

S&P recommends investors accumulate Wal-Mart (WMT), Michaels Stores (MIKE), and Ann Taylor Stores (ANN). All are ranked 4-STARS. S&P also recommends avoiding Intimate Brands (IBI) and selling Gap (GPS).

Q: I'm thinking of buying homebuilder DHI

(D.R. Horton) -- what's your take?

A: Unfortunately, S&P doesn't currently cover the company. However, S&P has become more bullish on homebuilders. In early December, S&P homebuilding analyst Michael Jaffe upgraded many of the homebuilders he follows, following strong November, 2001, orders. He upgraded KB Home (KBH) to 5-STARS (buy), and Pulte Homes (PHM) and Centex (CTX) to 4-STARS (accumulate). He also considers Lennar (LEN) shares worthy of accumulation.

Q: How will the travel industry fare? Any bets to place there?

A: Following the tragic events of September 11, many of the travel-related stocks sold off precipitously.... However, recent sentiment has improved in this industry, helped by favorable events in Afghanistan, expectations of improved consumer willingness to travel, and prospects for stronger economic conditions ahead. S&P leisure analyst Thomas Graves upgraded the shares of PPE

(Park Place Entertainment), a major operator of casino hotels in Las Vegas. And he also ranks Cendant Corp. (CD) a 4-STAR.

Q: Are lower energy prices S&P's main reason for its lower ranking of energy companies?

A: S&P ranks the energy sector at market-weight. Currently, S&P favors companies such as Exxon Mobil (XOM), ChevronTexaco (CVX), and Nabors Industries (NBR), all ranked 5-STAR. Generally, S&P energy analysts favor the well-capitalized market leaders for long-term investors.

Q: Exxon Mobil did not really rise when crude prices were high. Now, it's not really dropping, What is the link between oil and share prices? We own a lot of it and are mystified by its "independence."

A: Exxon Mobil has a vertically integrated oil exploration, production, and transportation business model, which allows the company to benefit from low oil prices. But at the same time, the company can benefit during times of high oil prices, as it can pass these prices on in its downstream chemical division. On balance, Exxon Mobil's profit margins do not fluctuate widely, given this balance of operations, and is therefore an excellent choice for investors who don't wish to try to time oil prices.

Q: How widely do you think the ripples from the Enron (ENE) collapse will spread? Has it affected your rankings?

A: S&P currently ranks Enron as a 2-STAR (avoid), in light of their well-documented troubles. However, S&P independent power producer analyst Craig Shere recommends speculative accumulation on Dynegy (DYN), Mirant (MIR), and Calpine (CPN). These shares have sold off precipitously in recent weeks, following the Enron debacle and lower electricity prices, creating an opportunity for risk-tolerant investors to accumulate these leading power generators for long-term gains.

Q: Some analysts worry about the financial stocks, because of interest-rate and credit-quality concerns. How does S&P view the financials?

A: S&P currently has a market-weight recommendation on the financial sector. S&P remains concerned that the still-sluggish economic conditions will continue to pressure the results of many companies in the sector. In addition, despite the Fed's more accommodative stance, S&P remains concerned that many financial institutions may face an environment of weakening credit quality, and thus experience pressure on loss provisions and loan growth, and a low degree of earnings visibility.

S&P recommends that investors in the financial sector emphasize high-quality regional banks, select asset managers, and REIT stocks. S&P also favors personal lines property-casualty insurers and life insurers, both of which are well positioned to benefit from the rise in premium rates that followed the September 11 tragedy.

Q: Specifically, some names in those categories you recommend?

A: Some of the current favorite financial-sector stocks include: AIG

(American International Group), Eaton Vance (EV), Arthur J. Gallagher (AJG), and MetLife (MET). S&P's favorite REIT is Boston Properties (BXP) -- the company's dividend yield exceeds 6% right now.

Q: Has the war on terrorism caused any changes in S&P recommendations, up or down?

A: The most significant change to S&P's recommendation list, as a result of the war on terrorism, has really been on the insurance and insurance brokerage area in light of the rising premium-rate environment. Again, leading beneficiaries here include Allstate (ALL), Marsh & McLennan (MMC), and Berkshire Hathaway (BRK.A).

Q: So as the hour wanes, sum up for us a few of S&P's top picks for the new year, Ken.

A: My personal favorites for '02 are: Mohawk Industries (MHK), a leading maker of carpet with widely recognized brand names that should continue to benefit from strong housing sales and low raw material prices; FEI Co. (FEIC), a semiconductor-equipment maker that's enjoying strong growth because of the need for a deep, submicron-level metrology at semiconductor manufacturers; and Biomet, a manufacturer of medical devices.

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