Stocks: Volatile, but Trending Higher

That's the analysis of S&P's Sam Stovall, who also explains why he sees energy stocks remaining a good bet in the year's second half

The stock sectors to stress now in a portfolio are energy and consumer discretionary, according to Sam Stovall, senior investment strategist for Standard & Poor's. He expects both of those areas to benefit from a gradual improvement in the economy and from the leveling off of oil prices. However, all 10 sectors in S&P's coverage are represented on the current list of stocks ranked as 5-STARS, or strong buys.

In the near term, Stovall expects the market to remain volatile, though it should trend higher in the coming months. And he sticks with a forecast of 985 on the S&P 500-stock index by yearend.

These were among the points Stovall made in an investing chat presented May 20 by BusinessWeek Online and Standard & Poor's on America Online (like BusinessWeek Online, S&P is part of The McGraw-Hill Companies). He was replying 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.

Sam Stovall is an employee of Standard & Poor's Investment Advisory Services (SPIAS). He is also a registered representative of S&P Securities, an affiliate. Affiliates of SPIAS may provide services to companies under discussion. Neither SPIAS nor Sam Stovall (or any member of his household) owns stock in the companies under discussion. He is not affiliated with any of the companies under discussion. Investors should discuss any investment in detail with their financial adviser.

Q: So what's the market sentiment at S&P? Do you see any sign of a clear direction?


In the near term, I think investors are still likely to see a volatile market, as many are still skeptical about the longer-term direction for our economy and earnings and are also concerned about near-term events surrounding terrorism, mad cow disease, and the Supreme Court decision on pharmaceutical stocks. But S&P still believes the market's direction is higher over the next several months, and our yearend price target remains at 985 for the S&P 500.

Q: Here's a chance to pick among the S&P 5-STARS -- what's your favorite stock for appreciation over the next six months?


Like asking a father to select their favorite child, I can't whittle our list of 100 stocks with strong-buy recommendations down to one, but I can introduce you to our Top 10 Portfolio, which is a list of 10 stocks that each carry a 5-STARS, or strong buy, ranking by S&P analysts. Those stocks (in alphabetical order) include: Alberto Culver (ACV ), Boston Scientific (BSX ), Comcast A (CMCSA ), Compass Bank Shares (CBSS ), Dean Foods (DF ), Jacobs Engineering (JEC ), Martek Biosciences (MATK ), Nabors Industries (NBR ), Pfizer (PFE ), and finally USA Interactive (USAI ).

Q: What is your feeling on BellSouth (BLS )? Do you see hope for the telecom sector?


S&P maintains an underweight recommendation on the telecom sector, which is heavily influenced by the integrated telecommunications industry in which BLS is found. We currently have a 2-STARS or avoid recommendation on the BLS shares because we believe the company will experience increasing competition and earnings quality issues.

There's only one integrated telecom stock with a 5-STARS ranking, and that's Alltel (AT ) -- because the company has relatively strong earnings quality and is facing less competitive pressure than the former Bell operating companies.

Q: Opinion on Pfizer (PFE) and J.P. Morgan Chase (JPM )?


Pfizer is the only major pharmaceutical firm that we rank strong buy. Yet we maintain accumulate rankings on Johnson & Johnson (JNJ ), AstraZeneca (AZN ), Aventis (AVE ), Eli Lilly (LLY ), and Wyeth (WYE ).

J.P. Morgan Chase, however, is a different story. The JPM shares are ranked 2-STARS or avoid. The company continues to have sizable credit-risk exposure to troubled industries. In addition, the business mix is heavily exposed to capital markets, which we believe makes for greater earnings risk than its peers.

Q: Your thoughts on mortgage REITs, please. Is the bloom off real estate?


We still favor a few real-estate investment trusts. We have 5-STARS rankings on Chelsea Property Group (CPG ), which develops and leases outlet centers in metropolitan areas. We also have a strong buy ranking on Vornado Realty (VNO ), which develops and manages retail and industrial properties in the Midatlantic and Northeastern U.S.

Q: How about USA Interactive (USAI ) and/or affiliated companies?


This one we like very much and have the USAI shares ranked 5-STARS. This leader in interactive commerce should (in our opinion) benefit from rising levels of Internet users and usage, along with a rebound in discretionary spending should U.S. economic growth accelerate in the second half of this year, as we project.

Q: Sam, what's your view on prospects for deflation in the U.S.? And how would one best invest if deflation happens?


We first off don't think that deflation is a likely scenario within the U.S. because a weakening dollar is actually inflationary, since it raises the costs of imported goods and allows greater pricing flexibility by domestic producers. If the U.S. should, however, experience a deflationary environment that is deep and sustained, it will likely be because we were drawn into it by a deflationary worldwide economic scenario.

Initially, U.S. investors might gravitate toward defensive areas within our marketplace, such as health care and consumer staples. Yet longer term -- as was seen in the 1930s -- the safest place to be in a lengthy deflationary environment is short-term Treasuries. We don't...expect this type of a scenario.

Q: What is the future for General Electric (GE )?


We think the GE shares are worth holding at this point. The faltering global economy continues to hamper its financial results. Yet, longer-term, we believe free cash earnings will grow at a sustainable 6% to 9% growth rate.

Q: What is your view on restaurant stocks? Any favorites?


In general, we are neutral on the restaurant stocks. Of the more than 30 stocks that we cover in the restaurant industry, the following carry 4-STARS or accumulate rankings: Applebee's (APPB ), Bob Evans Farms (BOBE ), Darden Restaurants (DRI ), Landry's Restaurants (LNY ), Ruby Tuesday (RI ), Wendy's (WEN ), and Yum Brands (YUM ). We have one restaurant stock ranked 5-STARS, by the name of P.F. Chang's China Bistro (PFCB ).

Q: You mentioned underweighting telecom -- what sectors does S&P recommend overweighting in a portfolio now?


While we have about 95 stocks in our 5-STARS list, and all 10 sectors in the S&P are represented, we currently favor the consumer discretionary and energy sectors because of the expected improvement in the U.S. economy and the benefit from oil prices that will likely remain above $25 per barrel. In general, we think that many industries and companies in the economically sensitive sectors should be leaders as U.S. economic growth improves in the second half of 2003.

Q: What do you think of Xerox (XRX )?


The Xerox shares have been on a tear recently and have shown very strong 12-month strength as investors hope for a fundamental turnaround. We, however, have an avoid ranking on the shares, given our expectation of continued weakness in the office equipment marketplace and because the shares are trading at a premium to the broader market.

Q: And another big name in many offices -- what's your opinion of IBM?


IBM (IBM ) carries a 4-STARS ranking. We reiterated our accumulate ranking after a company-sponsored analyst meeting where it confirmed its view that the information-technology industry should grow at a multiple of gross domestic product.... We came away from the meeting more convinced of the company's competitive strengths both in breadth and depth. The IBM shares are trading below our estimate of intrinsic value.

Edited by Jack Dierdorff

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