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A Market Stuck in Neutral

Investors will have to wait a few months more before stock prices head higher -- and the rise will be only modest, says Sam Stovall, senior investment strategist for Standard & Poor's. He says the market is now "locked in a trading range" as investors monitor corporate earnings and the recovery's progress.

S&P now recommends, he says, overweighting three sectors: technology, consumer discretionary, and materials. In tech, Stovall stresses the semiconductor and software industries and names such companies as Citrix Systems, Intuit, Brooks Automation, and Microchip Technology. In materials, S&P has buy rankings on Nucor, Pactiv, and Smurfit-Stone Container.

One concern is the Middle East, where increasing hostilities could drive up energy prices and slow the economic rebound. Speaking of the energy sector, Stovall says S&P's favorite among the giants is Exxon Mobil. Other S&P buys in the sector are GlobalSanta Fe and Nabors Industries.

Stovall made his observations on Apr. 2 in a chat presented by BusinessWeek Online and Standard & Poor's on America Online, in the course of replying to questions from the audience and Jack Dierdorff of BW Online. Edited excerpts follow. A full transcript is available from BW Online on AOL at keyword: BW Talk.

Q: Sam, the stock market has been having another sinking spell. How does S&P see the outlook now?

A: Our outlook remains that at least for the near term the market is locked in a trading range. This will likely last for the next few months as investors digest first-quarter earnings results and second-quarter earnings guidance and monitor the health of the U.S. economy. In the second half, we believe improving earnings and a rebounding economy will give investors reason to push share prices modestly higher.

Q: Can tech companies and Net companies (AOL, for one) survive?

A: Yes, tech will survive. And to the best of our knowledge, AOL will survive. Despite the volatile start for the year, we still believe technology is a sector that will likely improve as the year progresses. Ignoring today's setback for software companies, we still believe several are poised to perform quite nicely.

Our favorites include Citrix Systems (CTXS), Electronic Arts (ERTS), Intuit (INTU), and Siebel Systems (SEBL). We also favor semiconductor equipment and chip stocks, including Brooks Automation (BRKS) and Microchip Technology (MCHP). We currently have a 4-STAR [accumulate] ranking on the AOL Time Warner shares.

Q: Are those 5-STAR buys on the STARS list -- other than AOL's 4-STARS? And take a moment to explain STARS, if you will.

A: All of those companies just mentioned are on the S&P 5-STARS list. STARS is S&P's Stock Appreciation Ranking System. S&P's 50 equity analysts rank 1,100 stocks on a buy, hold, and sell basis.

Those with the best price-appreciation prospects over the coming 6 to 12 months receive 5-STARS. Those likely to keep pace with the overall market receive 3-STARS. Those likely to underperform the market receive a 1-STAR ranking. Since being introduced in 1987, S&P 5-STARS have posted a 17.8% average annual return through Feb. 28, 2002, vs. 10.5% for the S&P 500-stock index and 1.3% for 1-STAR stocks.

Q: What's your outlook on Merck (MRK)?

A: We are neutral on the health-care sector but negative on the pharmaceutical industry within this sector. Merck is currently ranked 2-STARS due to its own admission that earnings will be at best flat in 2002. Several other pharmaceutical firms have also expressed earnings concerns for this year.

Q: So which sectors does S&P suggest overweighting now?

A: We have overweight recommendations on technology (emphasizing the software and semiconductor industries, as previously mentioned), consumer discretionary, and materials. In consumer discretionary, those industries that will likely benefit from a multiyear surge in home sales include the housewares and home furnishings and appliance industries. Companies like Fortune Brands (FO), Leggett & Platt (LEG), and Mohawk Industries (MHK) are among our favorites.

In the materials sector, we favor the steel and containers groups. 5-STAR stocks in this sector include Nucor (NUE), Pactiv (PTV), and Smurfit-Stone Container (SSCC).

Q: Couldn't this latest war between the Israelis and Palestinians unsettle the stock market much more?

A: Yes, that is a real concern, primarily because of its impact on energy prices. High energy prices could slow our economic recovery. Higher prices at the pumps could have the same effect on consumer spending as a tax increase.

Also, higher energy prices would adversely affect corporate profits, particularly for transportation firms. In addition, the market does not like uncertainty, so this could cause investors to shy away from economically sensitive areas for the time being and embrace such safe havens as consumer staples stocks and gold.

Q: How about Boeing (BA)? How does that look to you, Sam?

A: Boeing shares carry a 5-STAR ranking. We think the company is likely to benefit from increased defense spending, as well as an improving worldwide economy.

Q: Speaking of energy, which you were a bit ago, how do you rate BP?

A: The shares of British Petroleum (BP) carry a 4-STAR ranking. In 2002, we see earnings at $1.96 per share, rising to $2.75 per share in 2003. Our favorite integrated oil company is Exxon Mobil (XOM), which is ranked 5-STARS. Other 5-STAR stocks in the energy sector include GlobalSanta Fe (GSF) and Nabors Industries (NBR).

Q: Now to a big tech name -- Cisco (CSCO).

A: We are neutral on the networking companies. Cisco carries a 3-STAR ranking, and only Black Box (BBOX) carries a 4-STAR ranking. The reason why we see this industry remaining under pressure is tight capital-spending plans by carriers worldwide.

Q: You recently added Green Mountain Coffee (GMCR) at 5-STARS. What's your feeling on this stock?

A: We view the 26% year-to-date decline in the share price as due to temporary factors. We see a 13% volume growth this year that will rise toward 20% growth next year. We see the shares trading at a 20% discount to their intrinsic value of $25 to $27 per share. It is also in a consumer staples sector, which tends to hold up well during periods of stock market uncertainty.

Q: What do you think of Lucent Technologies (LU)? Any hope?

A: Well, at least we have a hold ranking on the shares. The sector itself we carry an underweight recommendation on, and we believe it will take quite some time before investors are willing to jump back into most telecom equipment companies. The only telecom equip company that has a 5-STAR ranking is Qualcomm (QCOM).

Q: Can I ask what you think about Sun Microsystems (SUNW)? I bought it way back at $47, and it's $8 a share now.

A: Well, I'm sorry you're holding it at such a high price, but at least I can tell you that we're optimistic on a forward outlook on the shares.... Since the company continues to generate cash and is increasing its new-product introductions, we believe the shares are attractive. That's why we have them ranked 5-STARS.

Q: Outlook for Wells Fargo (WFC)?

A: Wells carries a 3-STAR ranking. 2001 earnings came in at $1.97 and are expected to rise to $3.25 next year. We have no major banks on our 5-STAR list. However, we do favor some smaller banks, such as Commerce Bancorp (CBH), National Commerce Financial (NCF), and Wilmington Trust (WL). These three are all ranked 5-STARS.

Q: Tyco (TYC) not long ago had a 5-STAR rating. What is the present rating?

A: The present rating is 3-STARS. The company warned that its December-quarter earnings could fall below the $0.76 consensus earnings estimate. But given Tyco's still mostly solid business trends, the shares look attractive at less than 10 times 2002 estimates. Yet we would wait for things to settle down before committing additional funds.

Q: How do you feel about LSI Logic (LSI)?

A: The LSI shares are ranked 5-STARS. We upgraded them back in February because we believe the chipmaker's fundamentals are improving, and the company has a chance to surprise on the upside. We saw the September quarter as the likely revenue bottom for this cycle.

Q: How long do you feel gold stocks will go up? Any S&P rankings there?

A: Gold stocks have done pretty well in the past year, climbing 12.4% last year and 24% in the first quarter this year. Reasons for their performance include: less competition from other "exciting" areas of the stock market, a reduction in central-bank sales of gold, the continued supply/demand imbalance, and the safe-haven characteristics that these shares offer. Barrick Gold (ABX) and Newmont Mining (NEM) are the largest in the S&P index, and both carry 4-STAR rankings.

Q: What rating do you have for Merrill Lynch (MER) and Lehman Brothers (LEH)?

A: The MER shares are ranked 4-STARS, while the LEH shares are ranked 5-STARS. For both companies, we think they're well positioned for the second-half advance we see in U.S. equity markets. The investment-banking component of the financial sector is likely to be one of the stronger performers in the year ahead as the economy and market recover.

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