DEE-fense! DEE-fense! Should Investors Heed the Cheer?

With the economic outlook so uncertain, lots of smart money is in stocks that can withstand the onslaught of bad news

It's an old saw in football: Defense wins championships. The same held true for Wall Street last year. With all the volatility in the markets of 2000, defensive stocks -- those of companies whose earnings are seen as being most resistant to a slowing economy -- were all the rage. While the Dow and tech-heavy Nasdaq were en route to some sizable losses, defensive issues such as Merck (MRK ), Boeing (BA ), and Philip Morris (MO ) posted impressive gains.

But with the Fed's interest rate cut on Jan. 3 -- and with analysts expecting more such moves to come -- could 2000's shining stars fade as investors turn once more to highflying growth stocks? Don't bet on it, say most experts. Defense still looks like a winning strategy.


  "I think we're going to see more of a rotation back into more defensive stocks that have consistent earnings growth and away from the higher-flying, high-earnings-growth stocks," predicts Harindra de Silva, co-manager of the Analytic Defensive Equity Fund (ANDEX ). He notes that the once-popular tech sector in particular continues to remain out of favor -- and with good reason. "A majority of the tech names are priced to reflect very aggressive revenue growth," says da Silva, but "the revenue growth isn't really materializing."

Similarly, Ken Shea, director of equity research at Standard & Poor's, believes investors are likely to benefit from a defensive stance in the near term. "Defensive stocks benefit when there's uncertainty in the market and there's rotation away from higher-growth areas such as technology. I don't see a whole lot that's going to change that."

Shea defines a defensive issue as a stock that typically has a lower beta -- a widely used measure of a stock's volatility -- than some high-growth and high-valuation stocks. He notes that although Fed rate cuts are typically a signal for investors to jump over to the higher-growth areas, there was no follow-through after the Jan. 3 announcement. "We don't think a 50-basis-point cut is enough for investors to de-emphasize a defensive approach," Shea says.


  But to some market observers, the defensive trend is played out. Bill Meehan, chief market analyst at Cantor Fitzgerald, believes these sectors will benefit only if there's a severe recession. "They always outperform in a very weak economic environment," he notes. And while they could provide reasonably good returns, Meehan doesn't think the risk-reward ratio is attractive.

Meehan expects select technology stocks, such as Apple Computer (AAPL ), to outperform. "As we go through choppy days, [defensive stocks] will attract some money," he says. "But I think the time to buy most of the defensive names, drug stocks in particular, was last March" -- when they were out of favor and tech stocks were ascendant.

Others believe that although a falling interest rate environment could result in money shifting out of safe-harbor names and back into growth, gains can still gains be made. "We don't see the Fed rate cut as causing the economy to accelerate at the rate it did in 1998, so we don't see a need to adjust our portfolio," de Silva says. His fund looks for stocks with consistent earnings streams that also aren't overly sensitive to overall changes in the economy. Some of his favorite defensive stocks are Kimberly Clark (KMB ), Equifax (EFX ), and Dominion Resources (D ).


  "Conventional wisdom would say don't fight the Fed," Shea says. "If the Fed starts easing rates, then it's time to jump into financials and technology." Shea adds that even with the recent Fed move, it's prudent to have a balanced portfolio emphasizing defensive names. That's because there's generally a lag between the time the Fed cuts interest rates and the follow-through, earnings improvement, and more important, improved earnings expectations.

But the experts realize the economy could always throw the markets a curveball. Shea says his outlook toward defensive stocks could change if the Fed becomes more aggressive in its rate cutting than he expects or if talk of a fiscal-stimulus package (such as President Bush's tax-cut proposal) builds. To Shea, though, it's corporate earnings that matter most: "If you don't get that, then all this other stuff is for naught."

Shea admits his opinion hinges on various economic forecasts. S&P predicts that gross domestic product will grow between 2.0% and 2.5% this year and that Greenspan & Co. will cut the Fed funds target rate by an additional 100 basis points by yearend -- a soft-landing scenario. "But at the same time, we're expecting a continued revision downward in earnings expectations for the foreseeable future," Shea says.

So, should investors stay in the foxhole? With the outlook for the economy -- and corporate profits -- deteriorating each day and experts predicting a rocky road ahead for the markets, it may not be a bad idea. Or as Shea puts it, until earnings expectations begin moving upward, "it's prudent to maintain a defensive posture."

By Alan Hughes in New York

Edited by Will Andrews

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