While Waiting for the Street to Get Back on Its Feet...

Waiting for the market to find a bottom? It could take a while. Here are the sectors to focus on in the meantime

By Sam Stovall

Those investors who believed that the Federal Reserve's unexpected 50 basis point cut in the Fed funds rate on Jan. 3 would throw the markets into a V-shaped recovery received a rude awakening on Jan. 5. They are now beginning to realize that they will likely be forced to wait out a bottoming and consolidation process before a slow recovery unfolds for stocks.

What happened? Through Jan. 4, a classic rotation out of the defensive sectors and into economically sensitive areas of the market was well under way. The S&P Consumer Staples, Health Care and Utilities Indexes gave up anywhere from 3.6% to 13.6% as investors snapped up shares of companies in the S&P Communications Services, Consumer Cyclicals and Technology Indexes, which jumped from 7.5% to 13.5%. What's more, the Nasdaq soared 14% during the afternoon of Jan. 3, which was close to the average gain of 15.7% posted by the index in the six months following initial rate cuts by the Fed since 1971.

But Friday, Jan. 5, proved to be a sobering day. The major indexes plummeted in the wake of disappointing retail sales and earnings pre-announcements, as well as a still-strong employment picture.

NO GROWTH. Now investors are wondering what will drive the market in the near term: earnings or interest rates? S&P believes that while the first of several interest-rate cuts should slow the descent of growth in the U.S. economy and overall stock prices (the Fed funds rate is projected to fall from 6.5% on Jan. 1, 2001, to 5.0% by the end of the year), weak earnings and unenthusiastic forward guidance will likely keep pressure on stock prices in the early part of this new year. S&P estimates that Q4 2000 earnings per share for the S&P 500 will be the same as Q4 of 1999 -- in other words, we should see no growth.

In addition, S&P 500 earnings should post a year-over-year decline of 3% in Q1 of 2001 and then zero growth again in Q2. For all of 2001, the S&P 500 should post a 5% advance in earnings, half of the estimate for 2000. What's more, nervousness over the SEC's Fair Disclosure rules will likely cause companies to offer limited and only near-term EPS guidance, which should exacerbate the negative attitude toward corporate profits.

BEST DEFENSE. As a result, S&P believes a defensive posture remains the best approach, especially since the possibility exists that the U.S. economy could slip into recession. Even though the S&P 500 and Nasdaq Composite averaged advances of 12.3% and 15.7%, respectively, in the six months after initial interest rate cuts since 1971, they posted negative returns from 4.5% to 19.1% during the recessions of 1981 and 1990. So while lower rates should aid the markets in the longer term, the near-term performances will likely be dominated by headlines about lower corporate profits.

What should investors do, then? S&P continues to recommend an overweighting of the Energy, Health Care and Utilities sectors, and an underweighting of the Basic Materials, Communications Services, Consumer Cyclicals and Technology sectors.

In particular, those industries with strong relative strength and STARS rankings include Hospital Management, Property/Casualty Insurers, Retail Drug Stores, Tobacco and Waste Management. Those industries with weak relative performance and STARS rankings include Autos & Auto Parts, Consumer (Jewelry, Novelties & Gifts), Long Distance Telecommunications, Photography/Imaging and Semiconductor Equipment.

Stovall is senior sector strategist for Standard & Poor's