While the S&P 500's recent rally off its Nov. 20 closing low of 752.44 represents a welcome reprieve after months of relentless selling, we believe a retest of the lows is likely.
Although recent volatility has at least discounted significant earnings erosion, as well as a looming global recession, the consensus also expects the economic and profit picture to improve in the second half of 2009. Should the current worldwide downturn be longer and deeper than expected, we think equities will be vulnerable to further selling when markets discount a bleaker than expected outlook. Given the unprecedented scope of global de-leveraging, hedging against a "longer and deeper" scenario appears prudent.
In addition, while the S&P 500's recent valuation of only 12.5 times 2008 estimated earnings may appear cheap by historical standards, the possibility of continued negative profit revisions means current valuations are likely higher than they appear.
The U.S. consumer, whose spending accounts for roughly 70% of economic activity, is under significant pressure — the result of weakening home prices, which we believe have further to fall because of a large inventory glut. In addition, international economic growth, whose past strength helped boost both U.S. exports and S&P 500 company sales, has weakened dramatically, with Europe, the United Kingdom, Canada, Japan, Australia, and New Zealand all in or flirting with recession. Overseas economic weakness has boosted the U.S. dollar, further eroding the benefit of the S&P 500 companies' approximately 45% foreign revenue exposure and exacerbating matters.
While equity prices will undoubtedly lead an upturn in the fundamentals, we believe the global economic and earnings outlook needs to at least show tentative signs of stabilization before any lasting rally will ensue. In light of this unprecedented global macroeconomic uncertainty, we continue to favor a defensive sector allocation.
We recommend underweighting this sector. Rising concerns surrounding the depth and duration of a U.S. recession are fueling ongoing erosion of the sector's earnings estimates. S&P analysts' fundamental outlook on the sector is negative, reflecting their negative outlooks for many industries, including department stores, automobile manufacturers, household appliances, and home furnishings.
We recommend overweighting the sector, reflecting our view of above-average earnings growth expectations and profit predictability. With the credit crisis showing no signs of abating, housing prices continuing to weaken, and the job market remaining sluggish, we believe investors may gravitate towards defensive, low-volatility sectors.
We recommend overweighting the energy sector, as we think low valuations will lead to a resumption of broader market outperformance. While WTI oil prices have dropped more than 65% since July, recent oil prices around $50 per barrel are still roughly in line with the past five-year average.
We recommend marketweighting this sector. As a result of the federal government's efforts to stem increasing investor pessimism, we believe the worst for this sector may be over. We believe that the government's Troubled Asset Relief Program (TARP), which has involved capital infusions into financial institutions, has lifted some of the uncertainty surrounding the sector.
We believe investors should overweight this sector. With our view that equity volatility will likely remain elevated, we think investors will reward the sector’s defensive qualities, allowing for better relative performance. S&P analysts have a positive fundamental outlook on the biotech industry based on an improved outlook for sales and earnings over the next 12 months.
We recommend underweighting this sector, as we think poor domestic earnings visibility is being aggravated by slowing international economic growth. With the U.S. recession accelerating and recessions now under way around the world, we believe this increasingly global cyclical sector is vulnerable to p-e contraction as investors increasingly question its future earnings growth outlook.
We advise marketweighting this sector based on our view that slowing global growth and a firmer dollar make outperformance unlikely. Even though the firming U.S. dollar should not materially hurt near-term results, in our opinion, the related unfavorable sentiment is a worry.
We recommend marketweighting the materials sector. We believe low valuations are offset by slowing global growth and a firmer dollar, which will likely temper the sector's revenue and earnings outlook. S&P analysts have a neutral fundamental outlook for the sector and see it being negatively impacted by slowing economic growth and raw material demand in, for example, Europe, Japan, and the United States.
We recommend overweighting the telecom sector, due to our positive fundamental outlook, its above-average yield, and improving technical readings. S&P analysts have a positive fundamental outlook for the sector, based on a positive outlook for the integrated telecommunication services industry, which makes up the vast majority of the sector’s market capitalization.
We recommend marketweighting this sector based on its defensive characteristics, its above-average dividend yield, and an improving technical outlook. S&P has a neutral fundamental outlook for the sector, based on our neutral view on several of the industries, including the electric utilities group, which represents nearly 60% of the sector.