Modest Gains, but Beware the Bear

That's view from Kenneth Shea of S&P, which has lowered some of its targets. Among the stocks still in favor: PepsiCo and Avon

"The recent market action is reminiscent to us of a bear market," says Kenneth Shea, managing director of Standard & Poor's Equity Research Services. He notes that expectations for second-quarter corporate earnings may have been a bit high -- but he also says that S&P expects modest gains for stocks by the end of the year.

Meantime, Shea reports, S&P has lowered its yearend target for the S&P 500 index from 1210 to 1150 (it's currently hovering around 1100). And the only sector S&P now recommends overweighting in a portfolio is energy. Reflecting this conservatism, S&P has also dropped its recommended asset allocation for U.S. stocks to 45% and raised the cash portion to 35%, with 10% each for foreign stocks and for bonds.

S&P still has a number of buy ratings, however, and Shea mentions Exxon Mobil (XOM ) in the energy group. In the information-technology sector, Shea suggests focusing on companies that have maintained earnings through business cycles, such as Automatic Data Processing (ADP ), IBM (IBM ), Microsoft (MSFT ), and Qualcomm (QCOM ). In this uncertain market environment, Shea says S&P also likes issues such as Wm. Wrigley (WWY ), Anheuser-Busch (BUD ), Avon Products (AVP ), PepsiCo (PEP ), Procter & Gamble (PG ), and Sysco (SYY ).

These were a few of the points Shea made in an investing chat presented Aug. 3 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BW Online on AOL, at keyword: BW Talk.

Note: Kenneth Shea is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies go to spsecurities.com and click on "Investment Research," and then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: Ken, the market continues to back and fill -- and as this audience member puts it: What is wrong with this market on the upside? How long will this last?

A:

S&P believes the stock market is likely to remain range-bound in the near term. The S&P investment policy committee just last week reduced its yearend S&P 500 target price to 1150 from 1210. This reflects concerns surrounding decelerating earnings growth and higher oil prices. Yet with the S&P 500 trading at about 19 times trailing 12-month GAAP [generally accepted accounting principles] earnings, vs. the 20-year average of 21.5, the IPC still sees modest gains by the end of the year.

The recent market action is reminiscent to us of a bear market. Positive fundamental news has been met by selling. Expectations may have been a bit high going into the second-quarter earnings season, and time will tell if expectations remain too high for the second half.

Q: I understand S&P has recently changed some of its recommendations on sector weighting and asset allocation. Can you fill us in?

A:

Over the last couple of weeks, S&P Equity Research Services raised its recommended emphasis on energy to overweight from market weight, and on utilities to market weight from underweight. It also reduced its emphasis on health care to market weight from overweight, largely reflecting a market that seems to be emphasizing more defensive attributes than before. This is reflective of a general deceleration of earnings growth and lingering geopolitical concerns that are weighing on high p-e sectors like information technology and, recently, health care.

With regard to S&P's recommended allocation, the investment policy committee two weeks ago reduced its recommended allocation of U.S. equities by 5% to 45%, while increasing its recommended allocation of cash by 5% to 35%. Its recommended allocation toward foreign equities remains at 10%, and bonds also remain the same at 10%.

Q: With energy at "overweight," what is your No. 1 energy idea, long term?

A:

For long-term investors, I believe that Exxon Mobil (XOM ) offers compelling growth prospects. Currently trading at a reasonable 15 times S&P's 2005 EPS [earnings per share] estimate, and sporting a secure 2.5% yield, these shares offer compelling risk-adjusted total return prospects. Longer term, this company's enormous size and global reach provide it with substantial competitive advantages and scale efficiencies vs. its peers that very few companies can match.

Q: Looking ahead to the election, would a change in the White House change your view on the market?

A:

Studies have shown that the market is generally unreceptive when the incumbent party is replaced. From a more fundamental perspective, S&P doesn't see substantial differences with regard to the earnings outlook in the aggregate in the scenarios of the different candidates.

While it's well documented that health care and energy are two areas that are likely to be under scrutiny, given the differing policies between the parties, S&P believes that demographic trends will continue to favor health care. And the growing long-term demand for energy, globally, will keep that sector in a growth mode.

Q: How about the financial sector generally, Ken, in light of rising interest rates? Any buys?

A:

S&P currently recommends underweighting the financial sector, which is comprised of 16 subindustries, serving the banking, insurance, consumer finance, real estate, and brokerage/investment management industries. Given S&P's expectation of gradually rising interest rates over the next 12 months, S&P believes that the associated negative investor perceptions will lead to reduced demand for banking activity, and this leads us to our cautious investment approach to the group.

S&P is positive, however, on certain consumer-finance companies, based on our expectations of healthy consumer spending. We're also positive on the property/casualty insurance industry, thanks to continued favorable premium growth trends, which we see starting to translate into improved operating earnings.

Q: Your opinion, please, on Vishay Intertechnology (VSH )? It dropped a lot recently.

A:

S&P downgraded the shares of Vishay to hold from buy this morning, as their second-quarter earnings report was in line with our expectations, but the lower backlog reported from Asia and Europe was disappointing. Our downgrade reflects concern over low second-quarter earnings momentum, flat orders we see for the third quarter, and risks of a backloaded year if momentum is slack until the fourth quarter. We lowered our 12-month target price to $15 from $29 to align it more appropriately (at a modest discount) to its peers.

Q: Will there be a rally in tech stocks in August?

A:

S&P recommends that investors market weight information technology, reflecting our more cautious stance on this economically sensitive sector. Our view has been tempered following second-quarter earnings reports, which have been affected by a slowdown in technology spending.

Given the sharp drops in many of the subindustries during July, many may speculate that a rebound is imminent, but S&P would take a more prudent approach and generally emphasize information technology stocks that have demonstrated earnings stability through cycles. Such stocks include Automatic Data Processing (ADP ), IBM (IBM ), Microsoft (MSFT ), and Qualcomm (QCOM ).

Q: Over to Internet security -- feelings on Symantec (SYMC )?

A:

S&P recommends investors accumulate shares of SYMC. It's a world leader in Internet-security technology. S&P projects revenue growth of approximately 25% in fiscal '05 (March), driven by continued strength in the company's anti-virus business. We also see results benefiting from recent acquisitions, as well as from its push into the enterprise market. The stock trades at a premium to its Internet security peer group, but...its leading market position, strong record of execution, and positive earnings outlook lead us to our accumulate recommendation.

Q: In the consistent growth category, like Wm. Wrigley (WWY ), what do you favor now?

A:

WWY is ranked 5-STAR (strong buy) by S&P, based mainly on its continued steady earnings growth, strong balance sheet, and relatively defensive business characteristics. To S&P, this is the type of company that seems to be an excellent choice in an uncertain market environment, such as the one we're in. Other similar choices include Anheuser-Busch (BUD ), Avon Products (AVP ), PepsiCo (PEP ), Procter & Gamble (PG ), and Sysco (SYY ). These are all companies that have demonstrated earnings and dividend growth through business cycles.

Q: Two more energy names -- feelings about Valero Energy (VLO ) and XTO Energy (XTO )?

A:

S&P recommends investors hold the shares of Valero Energy. VLO is the third largest U.S. petroleum refiner. S&P expects strong refining margins to boost near-term results. However, with the shares trading in line with its peers and yielding only about 1%, the shares appear to be a worthwhile holding.

S&P initiated coverage of XTO Energy in late July with a hold recommendation. As this U.S. natural-gas-focused exploration and development firm has successfully grown through acquisitions, and maintains strong growth and low-cost, long-lived reserves with an above-average organic replacement rate, our 12-month target price is $32.

Q: Masco (MAS ) and Sherwin-Williams (SHW ) seem reasonable as buys based on housing strength, etc. Your thoughts?

A:

S&P recommends a buy on Masco, whose recent earnings have reflected strong organic sales growth and market-share gains. Although S&P sees higher interest rates likely causing some slowing in new home and remodeling markets, we think demand for the company's products will remain solid. The company generates significant free cash flow, which supports its organic growth, and a secure dividend, which currently yields more than 2%.

S&P also recommends accumulating the shares of SHW, as the company continues to benefit from strong architectural paint sales and strength in domestic industrial maintenance and product finishes markets. Looking ahead, S&P sees improving international markets bolstering the company's sales and profitability, and we believe the shares are attractively priced for above-average total return.

Q: What's your opinion of The Williams Companies (WMB )?

A:

S&P recommends investors hold the shares of WMB. This company has sought to strengthen its balance sheet in the wake of credit, accounting, regulatory, and operating difficulties negatively affecting the energy-merchant industry in 2002 and 2003. Amid higher natural-gas prices, the company's earnings have benefited, and S&P sees initial signs of recovery in Williams' power margins in the Western U.S. The shares trade about in line with other diversified utilities. The shares appear poised for market performance ahead.

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