S&P's Market Outlook for 2003

Strategist Sam Stovall sees modest growth for the economy and major indexes. Best bets: Consumer, energy, and materials stocks

Look for a good but not great year in 2003. That's the essence of the message from Sam Stovall, senior investment strategist for Standard & Poor's. He sees 3% growth in real GDP and yearend 2003 figures of 1,050 on the S&P 500 (now around 900) and 1,660 for the Nasdaq (currently near 1,400).

Stovall reports that S&P's investment-policy committee has just voted to up its recommended asset allocation for stocks to 65% of a portfolio from 60%, with bonds unchanged at 15% and cash reduced to 20%. Given an expectation of improvement in both the economy and corporate earnings, Stovall says S&P encourages investors to overweight consumer-discretionary and staples stocks, as well as the energy and materials sectors.

Some of the names S&P has a buy ranking on in those sectors are Chico's FAS (CHS ), Mohawk Industries (MHK ), PepsiCo (PEP ), Smucker (JMS ), Apache (APA ), Nabors Industries (NBR ), Praxair (PX ), and Smurfit-Stone Container (SSCC ).

These were a few of the comments Stovall made in an investing chat presented on Dec. 10 by BusinessWeek Online and Standard & Poor's on America Online. He was replying to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Sam Stovall is an equity analyst with S&P's Investment Advisory Services. He has no affiliation with or ownership interest in any company under discussion. S&P's other affiliates may provide services to the companies under discussion today.

Q: At least for today, Sam, the market rally resumed. Are you optimistic for the rest of the year and for 2003?


Yes. For the rest of 2002, we think the market could undergo a Santa Claus rally driven by some additional economic reports showing that the economy is indeed turning around. Last week, our investment-policy committee voted to increase our recommended equity exposure to 65% from 60%, leaving bonds unchanged at 15% and reducing cash to 20% from 25%.

We did this because, as a group, we see both the S&P 500 and the Nasdaq rising about 15% in 2003, driven by a more consistent rebound in economic growth and a recovery in corporate earnings. Our yearend 2003 target for the S&P 500 is 1,050 and 1,660 for the Nasdaq.

Q: So you don't take November's 6% unemployment too seriously?


Not really. First off, you have to put everything into perspective. Since World War II, every recession (except the recession of 1970) saw the unemployment rate peak at above 7%. We see the unemployment rate peaking well below that threshold, since the most recent recession, like that of 1970, was very, very shallow. I'm very happy to suffer through 6% unemployment if I can still have the 5%-plus productivity gains that we've experienced recently. We forecast real GDP growth at about 2.5% in 2002, about 3% in 2003, and about 3.5% in 2004.

Q: Sam, what are the sectors to be in for 2003?


Because we're looking for a recovery in both the economy and earnings, and we also use history as a guide, we believe it best to emphasize the economically sensitive areas, such as the consumer-discretionary, energy, and materials sectors. But just to be on the safe side, we also advise a hefty exposure to consumer staples because of their reliable and transparent earnings growth.

We currently recommend underweighting health care, tech, telecom, and utilities. We see no fundamental change for telecom and think this group could remain under pressure for quite some time. The fundamental outlook for tech is improving, but it's still not likely to get much better until the second half of 2003.

Q: What are some of the stocks you like in those consumer and energy and materials sectors?


S&P ranks about 1,300 stocks on a buy, hold, and sell basis in STARS (our Stock Appreciation Ranking System) with 5-STARS being buys and 1-STAR being sell. Current 5-STAR stocks in these sectors include Chico's FAS (CHS ) and Mohawk Industries (MHK ) in the consumer-discretionary sector; PepsiCo (PEP ) and Smucker (SJM ) in the consumer-staples area; Apache Corp. (APA ) and Nabors Industries (NBR ) in energy; and Praxair (PX ) and Smurfit-Stone Container (SSCC ) in the materials sector.

Q: Should I stick with my current investments after losing so much? Many people may be asking the same question.


To answer that on a very broad basis, we believe that holding onto stocks as they have slid anywhere from 50% to 75%, only then to sell, is not an advisable thing to do, in general. Obviously, not all stocks will outperform in the months ahead, but we certainly do not advise investors who have both the risk tolerance and time horizon necessary to benefit from investing in stocks to be out of stocks entirely.

Q: What's your outlook for top utility companies?


We really have no utilities ranked 5-STAR. Our favorite 4-STAR (accumulate), however, is Entergy Corp. (ETR ). It engages in domestic-utility, domestic nonutility nuclear, and energy-commodity services.... Other electric utilities with 4-STAR rankings are Exelon Corp. (EXC ) and FPL Group (FPL ) -- that's it. Of the more than 20 electric utilities in our Super 1,500 Index, only three are ranked accumulate.

Q: Do you think the S&P will ever go up to 1,500 again?


Ever? Yes, and I hope it happens in my lifetime. If the S&P 500 rose 10% per year (which is its long-term average), it would take 5 1/3 years for it to go from the current level of around 900 up to 1,500. If you were a bit more bearish and were willing to forecast only about 7.5% growth per year, then it would take the S&P 500 a little more than seven years to eclipse 1,500.

So in other words, the answer is yes. It won't happen next year or the year after that, but it certainly could in the time period that is acceptable to most equity investors.

Q: I'm confused -- what justifies a 5-STAR rating in a decidedly down market? What are the criteria for a buy?


S&P analysts place 5-STAR rankings on those stocks that are expected to outperform both the market and their peers in the coming 6 to 12 months.... Equity analysts are not market timers -- their focus is on identifying companies with current share prices that are substantially below their intrinsic value.

And our analysts have done a very good job identifying future winners. The average annual performance from December 31, 1986, through November 30, 2002, is 15.8% for 5-STARS, vs. 8.9% for the S&P 500 and -2.9% for 1-STARS. Our list of 5-STAR stocks has outperformed in 11 of the last 15 years, underperformed three times, and tied once.

Q: Would the possible end of the double taxation of dividends be an opportunity to invest in dividend-bearing funds (or stocks)?


It seems as if Congress and the White House are willing to come up with some way to either end or ease the burden of double taxation of dividends (once at the corporate level and once at the individual level). About 350 companies in the S&P 500 pay dividends. This has helped them out quite a bit so far this year. Year-to-date through Nov. 29, while the S&P 500 declined 18%, the average dividend-paying stock fell only 8%, while the average nondividend-paying stock dropped 26%.

Higher dividend-paying sectors and industries could benefit from either a reduction or elimination of the double-taxation penalty. One group that could actually rise to the occasion, however, is information technology. This sector now offers an average yield of 1.3%, which is the lowest of all 10 sectors. Indeed, fewer than 20% of all tech companies in the S&P 500 pay any dividend at all. I think the end of this penalty would force many tech companies to rethink their dividend policy in order to win back investors who had left tech for dead.

Q: How will a war in Iraq affect your outlook?


That's certainly a wild card that has been with us for quite some time, but it's also a scenario that all investors have been aware of for at least the past 12 months. It's interesting, therefore, that investors would have been better off buying beer than bullets, since year-to-date through Nov. 29 the S&P brewers' index posted a 9.2% advance, while the S&P aerospace and defense index declined 7.3%. We have a negative investment outlook for the aerospace and defense industry.

Should the bombs start falling, more casualties than victors are likely to be seen on the equity front. One group that could be hit hard is transportation, which is made up of air freight, airlines, railroads, shipping lines, and truckers. Each may initially be hurt by the prospects for rising fuel costs amid concerns of oil-supply disruptions.

In addition, airlines and cruise lines could feel the added pinch of declining travel due to concerns about the possibility of renewed terrorist activity. Of course, if this conflict is rapidly resolved, as was Desert Storm, any downward movement in share prices would represent a buying opportunity.

Q: Are REITs under pressure from the real estate bubble? If indeed it is a bubble.


REITs are not under pressure from high or bubble-like retail-housing prices (depending on your point of view). REITs have been experiencing a sell-off because of renewed economic concerns over the health of the U.S. economy and its effect on office and retail leases. There are still several REITs that we favor, however. One is Hospitality Properties Trust (HPT ), which invests primarily in hotels. This stock carries a 5-STAR ranking and currently offers a dividend of 8.6%. We also rank the shares of Chelsea Property Group (CPG ) 5-STARS. This company is a retail REIT and currently offers a yield of 5.5%.

Q: Here's a good question to end with -- please name five stocks that have 5-STARS and would provide a balanced portfolio.


I will go one better. S&P introduced in the beginning of 2002 our Top 10 Portfolio, which consists of 10 5-STAR stocks in a multitude of sectors that were hand-picked by our director of equity research. These companies (in no particular order) are IDPH (Idec Pharmaceuticals), DF (Dean Foods), WMT (Wal-Mart), MCHP (Microchip Technology), NBR (Nabors Industries), PG (Procter & Gamble), MHK (Mohawk Industries), STZ (Constellation Brands), ABK (Ambac Financial Group), and CB (Chubb).

Edited by Jack Dierdorff

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