Playing Defense in the First Half

That's what S&P's Sam Stovall recommends, citing health care and utilities industries as prime sectors

Later in the year, the time may come to move back into technology and consumer cyclicals, says Sam Stovall, sector strategist for Standard & Poor's. But for now, he's stressing tocks in the energy, health-care, and utilities industries.

Nevertheless, he points to tech stocks that are now on S&P's best-buy list (5-STARS in its Stock Appreciation Ranking System). Among them are Emulex, RSA Security, Rational Software, and Symantec. S&P also has a buy rating on utility TXU Corp.

Stovall reports that GE warrants only a hold from S&P because of concerns over accounting questions in connection with the Honeywell acquisition -- and questions over performance after Jack Welch retires. AOL Time Warner also gets no more than a hold because of the slowing economy.

Stovall made these statements as part of a chat presented on Jan. 16 on America Online by Business Week Online and Standard & Poor's, in response to questions from the audience and BW Online's Jack Dierdorff. Edited excerpts from the chat follow. A complete transcript of this chat is available from BW Online on AOL, keyword: BW Talk.

Q: Sam, the market seems to have a slightly better tone today -- have we turned a corner, or is it just another blip?


From a technical standpoint, it seems as if we have at least established a bottom, if not started to make an actual turn. Usually, whenever the market performs well despite negative news, that is an indication that worst-case scenarios have already been built into stock prices. This may be just such an occasion.

Q: What tech stock would you buy now?


We currently have 12 tech stocks on our best-buy list. Those with the best near-term relative price performance -- and by that I mean, in the top 20% -- include Emulex Corp. (EMLX ), RSA Security (RSAS ), Rational Software (RATL ), and finally, Symantec Corp. (SYMC ).

Q: What's the outlook for GE after the Honeywell acquisition? And after Jack Welch steps down?


We have GE ranked 3-STARS, or hold. Our analyst Rob Friedman continues to question the quality of earnings because of their inclusion of an overfunded pension plan and the accounting actions that GE will take in regard to the Honeywell acquisition. We also believe that Jack Welch will be a very tough act to follow.

Q: What sectors do you think are the most beaten up, and therefore have the best potential upside?


In the year 2000, communications services, which is S&P's description of the telecom sector, fell nearly 40%, followed closely by a 38% decline in technology and an 18% decline in consumer cyclicals. Standard & Poor's currently recommends that investors maintain a defensive approach to the market by overweighting the energy, health-care, and utility sectors.

If the Fed remains aggressive in lowering interest rates, however, the sectors in a leadership role could change -- with technology and consumer cyclicals in the forefront. This has been a fairly consistent pattern during lower-interest-rate environments since 1971.

Q: What does S&P think of retailing generally, given slower consumer spending?


In general -- and in the near term -- we don't think that retailers are going to outperform the market, because of concerns over retail sales and weak earnings expected for the fourth quarter of 2000 and into early 2001.... Retailers remain, at best, market performers in the six months following an initial decrease of interest rates.

Q: Any opinion on AOL, now that the merger with Time Warner has cleared the hurdles?


S&P carries a 3-STARS, or hold, ranking on AOL Time Warner. We think the merger is positive for both companies, but believe a slowing U.S. economy will not cause the company to become a market outperformer.

Q: With California in mind, what's going to happen to electric-utility stocks?


We are currently neutral on the overall outlook for electric utilities. The activities in California will certainly cause state legislators in other states to rethink the deregulation process. Yet we do have some utilities ranked buy or accumulate. TXU Corp. (TXU ) carries a 5-STARS, or best-buy, ranking -- the only one in the group ranked buy. Allegheny Energy (AYE ) is ranked 4-STARS, as are a host of other electric utilities.

Q: Do you think the run is over for QCOM (Qualcomm)?


We have Qualcomm ranked 4-STARS.... We don't think that you'll have momentum investors chasing Qualcomm in 2001 the way they did in 1999, but we do see the company as a significant player in the communications-equipment category.

Q: What are your thoughts on EMC and others in the storage sector?


EMC currently carries a 4-STARS ranking. The storage area is likely to be a very big beneficiary of the growing Internet/intranet marketplace, whether it's because of broadband requirements or simply the need to retrieve old e-mail messages...and EMC is the leader in this category. We downgraded the EMC shares in late 2000 because of their overextended multiple, not because we see them losing their dominance in the industry.

Q: Some analysts think [President George W.] Bush is good for Philip Morris -- is MO a buy?


MO is a buy. The shares are ranked 5-STARS and are likely to continue outperforming the market in the coming six to 12 months.... In general, solid operating results and a planned IPO of Kraft Food should continue to propel the shares.

Q: Kmart (KM ) seems to be catching fire -- what's happening here, Sam?


I think what's happening is that investors are doing some bottom-fishing and buying the beaten-down industries and companies that may rebound in the face of an aggressively easing Fed over the next year. The retail [general-merchandise] industry, in which Kmart is found, fell more than 20% last year. S&P currently ranks two members of this industry favorably. BJ's Wholesale Club (BJ ) is ranked 5-STARS, and Wal-Mart Stores (WMT ) is ranked 4-STARS. The rest, including Kmart, are ranked 3-STARS, or hold.

Q: What's your opinion on GLW [Corning]?


This communications-equipment company was downgraded on Dec. 20, to accumulate from buy. Despite strong business trends, there was a concern over lower capital spending and a potential fiber glut. We think these issues could cloud the stock in the near term, but even with the recent price decline, the shares are trading at a still-hefty valuation.

Q: I would like to know your No. 1 pick for 2001 -- or even your top five!


I am not in that business, but I will give you [some historical perspective]. Since 1970, if an investor were to buy the top 10 industries in the S&P 500 during the month of January and hold these for the remaining 11 months of the year, this "portfolio" would have outpaced the S&P 500 by a near 2-to-1 ratio. In 2000, even though the S&P 500 fell 10.1%, these 10 industries averaged a gain of 23.6%.

Q: Our time is running out, so how about summing up S&P's macro outlook for the 2001 economy and stock market?


In summary, S&P believes that the economy will slow quite dramatically but will not fall into recession. An aggressive Fed, by reducing the Fed funds rate by as much as 150 basis points in total by the middle of this year, should keep a soft landing intact. Lower interest rates are likely to keep a floor under, or provide support for, stock prices in the near term.

Weak earnings, however, are likely to keep pressure on overall stock prices. As a result, a "U-shaped" recovery is expected, rather than a "V-shaped" recovery. Stick with the defensive sectors like energy, health care, and utilities early in the year, but be ready to move into the economically sensitive areas as the year progresses.

Edited by Jack Dierdorff