Investors Wait for a "Positive Catalyst"

Meanwhile, they're wary and uncertain, says S&P's Kenneth Shea, who sees little reason now to loosen the reins of caution

The stock market as measured by the Standard & Poor's 500-stock index could grow 7% to 10% annually over the next three years, assuming that corporate earnings continue to gain ground. That's the view expressed by Kenneth A. Shea, vice-president and director, Standard & Poor's Equity Research & Services.

The problem is that, at the moment, investors are troubled by uncertainty and don't see a "positive catalyst," Shea says. In that situation, only 90 of the 1,200 stocks listed in S&P's Stock Appreciation Ranking System (STARS) carry a 5-STAR or strong buy rating. Shea reports that S&P now recommends only four stock sectors for overweighting: consumer discretionary, consumer staples, energy, and materials. Examples of buy-ranked stocks in those categories include Wendy's, Procter & Gamble, ExxonMobil, and Smurfit-Stone Container.

In keeping with S&P's relatively cautious outlook for stocks in the near term, Shea says it recommends a conservative allocation of assets: 60% stocks, 15% bonds, and 25% cash or cash equivalents.

These were among the points Shea made in a chat presented Sept. 24 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Ken, the bear is still on a rampage. Do you see a bottom? How low do you think the S&P probably will go?


Clearly, investors are in a sour mood right now, reflecting a combination of factors, including the prospect of going to war with Iraq, worries over corporate profits, concerns about many financial firms, and so on. And it's unlikely that investor sentiment will improve enough to reverse this downtrend, unless a positive catalyst emerges.

The problem is that there doesn't seem to be [a catalyst] in the near-term horizon. From a fundamental point of view, S&P analysts anticipate a gradual improvement in operating earnings over the next few quarters.... Assuming that earnings continue to gain ground, S&P expects the S&P 500 to grow in line with earnings growth, which S&P anticipates to be between 7% and 10% annually over the next three years.

Q: What criteria do you use to choose top-rated stocks?


S&P emphasizes companies that are market leaders, or close to that, in their given industry, have an established track record of generating positive cash flows, have a p-e/growth multiple which compares favorably to that of the S&P 500, and look attractive on a technical basis. These four elements comprise the majority of what we look for in a 5-STAR stock, which is a strong buy recommendation from S&P [on the STARS Stock Appreciation Ranking System].

Q: How can an investor know when you change your opinions?


S&P analysts disperse their STAR-ranking changes on a continuous basis, mainly through S&P MarketScope, BusinessWeek Online, and also in the S&P Outlook weekly newsletter.

Q: Are there any stocks you would buy today?


At the present time, S&P equity analysts evaluate more than 1,200 stocks in its STARS ranking system. Of those 1,200 stocks, only 90 -- or fewer than 8% --carry a 5-STARS or strong buy ranking. Some of these include: Hovnanian Enterprises (HOV ), Dean Foods (DF ), Ambac Financial Group (ABK ), St. Jude Medical (STJ ), and Landstar System (LSTR ). These companies have good earnings growth characteristics, yet very reasonable valuation levels, and therefore qualify as attractive near-term and longer-term investments.

Q: On to specific stocks -- your opinions on FedEx (FDX ) vs. United Parcel Service (UPS )?


S&P analyst Jim Corridore ranks FedEx as a 5-STAR (strong buy), as the company's ground volume growth is impressive, and its freight business is also healthy, benefiting from the bankruptcy of Consolidated Freightways (CFWEQ ). FedEx's stock trades at a significant discount to that of the S&P 500 and its peers. It, therefore, warrants purchase for investors seeking capital gains. UPS, however, is ranked by Jim as a 3-STAR (hold) as the shares are richly valued relative to its package delivery peers and low-teens earnings growth rate.

Q: What is your opinion of supermarket stocks Albertson's (ABS ), Kroger (KR ), and Safeway (SWY )?


Year to date, the S&P food-retail index has performed relatively in line with the S&P 500 index. S&P is negative on this industry, as we believe the major food chains will struggle to maintain earnings growth, reflecting increased competition from the likes of Wal-Mart (WMT ).

S&P analyst Joe Agnesi ranks Albertson's as a hold.... S&P ranks Kroger also as a hold.... A similar story is Safeway (SWY ), also a hold recommendation. The p-e multiples for all three companies are relatively low, but are not, we believe, sufficiently attractive for investors in light of an increasingly competitive market environment. And we would, therefore, not advise new commitments.

Q: How about Harley-Davidson (HDI )?


S&P analyst Will Donald recommends investors accumulate (4-STARS) the shares of this leading maker of heavyweight motorcycles, as continued strong demand for the company's products keepss revenues and earkeepsin a solid uptrend. Longer-term, S&P belives the company's mbelieveseadership position will enable healthy pricing and continued interest for the products. The company's finances are sound, with relatively low debt levels, which are helped by the company's consistent and steady cash flow gains.

Q: Is Disney (DIS )a buy yet?


S&P views Disney as a worthwhile holding, as the company's attractive assets are being offset by some near-term weakness in its theme-park attendance and its ABC-TV network. In addition, the company has had a relatively high level of unexpensed stock options in recent years, which could limit future share gains. S&P does not advise new commitments in Disney at this point.

Q: The Fed announced today there would be no change in interest rates. Every time Alan Greenspan speaks, the market drops. Is it his demeanor or his negative outlook?


The Fed's decision today to hold the fed funds rate at its 41-year low of 1.75% was not a surprise to S&P, which continues to expect no further cuts from the Fed until probably next summer. At that time, the move will probably be up, not down.

Q: What do you think of Washington Mutual (WM )? How about the financials generally?


S&P recommends that investors market-weight their exposure to the financials sector, which is composed of nine industries serving the banking, insurance, consumer finance, real estate, and brokerage/investment management industries. Although S&P's outlook is neutral, we are positive on some subsegments such as property/casualty insurance companies, real estate investment trusts, and insurance brokers. Most of the other segments get a neutral view.

With regard to Washington Mutual, S&P recommends "accumulate," as S&P believes this company can generate income growth in a variety of interest-rate environments.... Trading at a very reasonable nine times projected earnings, and offering a near-3% dividend yield, Washington Mutual, in S&P's view, is an attractive long-term investment.

Q: What sectors within S&P do you think will outperform over the next 12 months to 24 months?


S&P recommends investors overweight the consumer discretionary, consumer staples, energy, and materials sectors. These sectors, in general, have fairly defensive characteristics and reasonable valuations in an uncertain market environment.

Q: My thrift savings through the U.S. Postal Service is invested 100% in the S&P 500 -- is that a good or bad idea in these times?


The S&P 500 offers investors a broad exposure to the equity markets through its diversification into the major economic sectors and industries within the U.S. economy. From an asset-allocation standpoint, S&P recommends long-term investors allocate 60% of their assets toward stocks, 15% toward bonds, and 25% in cash or cash equivalents. On balance, this asset allocation mix is a relatively conservative one -- but is consistent with S&P's relatively cautious outlook for stocks in the near term.

Q: Is it a good time to buy General Electric GE ?


S&P analyst Robert Friedman recommends that investors hold GE, but not add to their positions or establish new positions. The shares appear fully valued relative to the company's projected earnings growth prospects.

Q: What do you think about the drug and biotech sectors?


S&P has a relatively cautious outlook on the major pharmaceutical companies, as they remain challenged by key product patent expirations, a more restrictive FDA, and new initiatives on the state level to rein in rising drug costs. As a consequence, S&P believes industry earnings growth is likely to decelerate to the high single digits annually over the next few years, down from mid-teen earnings growth levels seen over the past decade.

S&P is a bit more positive on the biotech industry, however, as a recent dose of strong financial results by a number of prominent biotech companies has created some excitement. Examples here are the recent success for Amgen's (AMGN ) Aranesp, which was approved in July to treat anemia associated with chemotherapy use, and Gilead Sciences' (GILD ) Adefovir Dipivoxil, which received a unanimous recommendation from an FDA panel for approval to treat hepatitis B. Amgen is rated 4-STARS (accumulate), and Gilead Sciences is rated as a strong buy (5-STARS).

Q: Ken, can you give us some 5-STAR names from the sectors S&P recommends overweighting now? Consumer staples and consumer discretionary, energy, and materials?


In the consumer discretionary sector a few 5-STARS are Chico's FAS (CHS ), Fortune Brands (FO ), and Wendy's International (WEN ). In the consumer staples sector, some 5-STARS include Procter & Gamble (PG ), Sysco (SYY ), and Tyson Foods (TSN ). In the energy sector, three 5-STARS are Apache (APA ), ExxonMobil (XOM ), and Nabors Industries (NBR ). In materials, S&P ranks as 5-STARS IMC Global (IGL ), Praxair (PX ), and Smurfit-Stone Container (SSCC ).

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