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Stocks Suffer as Rockets Fly

From Standard & Poor's Equity Research

As if slowing earnings growth, rising inflation, and a tighter monetary policy weren't enough, the escalating conflict between Israel and Hezbollah is pushing geopolitical unrest to the forefront of investors' minds, and aggravating volatility in global equity markets.

As of Friday morning, July 21, Israel continued to pound Hezbollah positions in Lebanon and roadways between Lebanon and Syria, which with Iran sponsors the terrorist group. Israel is also warning inhabitants to flee southern Lebanon before a likely ground assault to establish a deep buffer zone. The crisis was triggered on July 11, when Hezbollah kidnapped two Israeli soldiers in a cross-border raid.

And, of course, the nuclear ambitions of Iran and North Korea are still lurking in the background. The United Nations Security Council, in a rare show of unity, condemned North Korea's July 4 missile tests. Pyongyang "vehemently denounced" the resolution, and thundered that it would "bolster its war deterrent for self-defense," believed to be a reference to its nuclear weapons program. Kim Jong Il, investors have been duly reminded, represents a real and present danger to Asian stability. Although his aim in making nuclear threats may be largely financial, we think his biggest bargaining chip, the possibility of a unilateral attack against his neighbors, remains. Tokyo and Seoul are within range of his missiles.

Moreover, the increasing intransigence of President Mahmoud Ahmadinejad suggests to us that Iran is determined to reject any form of cooperation, despite increasingly attractive financial "olive branches." On July 13, Ahmadinejad threatened to revise Iran's cooperation with international bodies monitoring its nuclear program.

The strong correlation between rising geopolitical unrest and record energy prices only exacerbates the latter's impact on world stock markets, in our view. With global oil production capacity tight, traders worry that oil prices are vulnerable to even minor supply disruptions. West Texas intermediate crude oil hit new all-time highs on July 14, surging to nearly $78 per barrel in the face of escalating tensions in the Middle East and renewed rebel attacks on Nigerian oil pipelines. Attacks by Nigerian militants this year have cut output of crude oil by 500,000 to 800,000 barrels a day. Nigeria is one of the top five suppliers of oil to the United States.

The S&P Investment Policy Committee recently lowered its 2006 year-end S&P 500 index target to 1315, representing price appreciation of 5% from year-end 2005. Although by no means the only headwind that equities face, geopolitical tensions are a significant reason for our more cautious second-half outlook. At the sector level, S&P Equity Strategy recommends overweighting the energy sector as a way of hedging the negative effects of increased geopolitical risk and stubbornly high oil prices. In addition to having what we consider excellent earnings predictability in uncertain times, the energy sector is the least expensive in the market, trading at 10.5 times estimated 2006 earnings vs. 14.5 for the S&P 500 index. The accompanying table lists our five-STARS picks in this sector.

The oil hedge

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