We believe the expected stimulus to economic growth, corporate earnings, and consumer spending from seven interest-rate reductions and a more than $100 billion tax rebate program may at least be partly offset by concerns surrounding the impact of rising food and energy costs on consumer spending, and the speed with which the Federal Reserve potentially reverses course and begins to raise short-term interest rates.
Though large-cap, U.S. equities likely face challenges in the second half, S&P equity analysts are projecting an 8% increase in full-year operating earnings for the S&P 500, which is down from the 16% estimated growth on January 1. Nine of the 10 sectors in the S&P 500 are projected to record earnings increases — only financials is expected to post a full-year decline, 24%. Only the consumer staples and energy sectors have seen progressive increases in full-year earnings growth estimates.
If there is a sweet spot in the U.S. equity market, we think it is the mid-cap equity arena, for at least three reasons. First, investors realize they can get higher-octane results from the more nimble smaller-cap stocks, as they typically outpace larger-cap issues when the equity market is on the upswing. At the same time, they also maintain the more defensive qualities that larger-cap, multi-national companies traditionally offer during challenging economic periods.
Even though the financials and information technology sectors are among the largest across all index cap-sizes, within the S&P MidCap 400, significant disparities are found in the high-flying materials and utilities sectors. These two groups each represent less than 4% of the weighting of the S&P 500, but comprise more than 8% of the S&P MidCap 400.
In addition, while the international integrated oil companies dominate the S&P 500 energy sector, it’s the upstream exploration & production companies (those that benefit most from rising oil prices) that dominate the mid-cap benchmark.
Lastly, S&P equity analysts, who cover about 70% of the companies in the S&P MidCap 400, are projecting a 16% increase in operating earnings for the 400 in 2008, as compared with only an 8% estimated rise for the S&P 500. Plus, despite a higher P/E on 2008 estimated earnings for the mid-cap index, the PEG (P/E-to-growth) on estimated 2008 results is more attractive for mid-caps at 1.0 times vs. the 1.8 times for the 500.
Our outlook for small-cap issues remains neutral, as the increasing likelihood of a delayed recession is expected to cap earnings growth. While Wall Street consensus estimates call for a 9% rise in operating results (S&P equity analysts cover only about 30% of the stocks in the S&P SmallCap 600 index), valuations appear a bit stretched to us at 19 times estimated 2008 results vs. 15 times for the 500.
For all three cap sizes, 2008 estimated earnings growth is projected to be substantially stronger for the growth side of the ledger than the value side. At the S&P 500 level, growth stocks are expected to post a 13% rise in 2008 earnings vs. a 2% rise for value stocks. Mid-cap growth issues should see a 23% advance in earnings, while value issues are expected to see a 7% advance. Finally, small-cap growth should post a 14% gain in operating earnings this year, leading the 3% rise expected for the small-cap value group.
S&P equity analysts also have a more favorable investment outlook for large- and mid-cap growth stocks, as compared with their value peers. The S&P 500 Growth index sports a market-cap weighted STARS (Stock Appreciation Ranking System) average of 3.81 vs. the weighted STARS average of 3.68 for the S&P Value index. Of the 278 companies in the S&P MidCap 400 index with S&P STARS (70%), the Growth index carries a more favorable 3.42 market-cap weighted STARS average vs. a 3.30 average for the Value index. STARS are not computed for the S&P SmallCap 600 index, due to the limited STARS representation.
Sectors within the S&P 500 that have pronounced (greater than 60%) growth leanings include energy, health care, and information technology. Consumer staples missed the cutoff at 57%. Sectors that have pronounced (greater than 60%) value leanings include financials, telecommunications services, and utilities. Industrials just missed the cutoff at 58%.
S&P’s Equity Strategy group recommends overweighting the information technology and materials sectors, while underweighting health care and utilities. For technology issues, we see the effects of a mild U.S. recession already largely discounted in current valuations. In addition, the materials group traditionally outperforms during periods of inflationary concerns, as investors gravitate toward these so-called real asset issues. We currently recommend a market-weighting on the energy group, however, as we anticipate a decline in oil prices on new international production and technical considerations.
We recommend underweighting the health care sector, as the group’s defensive appeal appears to be evaporating in the face of sparse drug pipelines and growing margin pressure. Finally, we think utilities issues may underperform in the period ahead, as a result of a decelerating second-half earnings forecast, combined with above-market P/E and PEG ratios.