"A Good Yearend Rally"

If 2003 plays out as expected, S&P's David Braverman looks for stocks to be 8% to 10% higher. Plus: S&P's current picks and pans

Cautious optimism is the theme of Standard & Poor's market forecast these days. David J. Braverman, senior director and portfolio investment officer of S&P, thinks a correction could come along in the summer, followed by new highs toward yearend, on the order of 8% to 10% higher.

Braverman reports that S&P now recommends overweighting only two market sectors, consumer discretionary and energy. But it actually has the most strong buy recommendations in financials and health care because those sectors are a much larger part of the market. At the other extreme, according to Braverman, S&P suggests selling Level 3 Communications (LVLT ) because of concerns over its cash flow being sufficient to service its debt.

Ten of the S&P strong-buy stocks are grouped in a recommended portfolio: American Standard (ASD ), Bank of America (BAC ), Boston Scientific (BSX ), Capital One (COF ), FedEx (FDX ), Fair Isaac (FIC ), Lennar (LEN ), PepsiCo (PEP ), Pfizer (PFE ), and Exxon Mobil (XOM ).

Braverman made these remarks in an investing chat presented July 1 by BusinessWeek Online and Standard & Poor's on America Online, in 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.

Q: David, the first half of the year is behind us, leaving behind a degree of optimism. What do you foresee for the rest of the year?

A:

We're cautiously optimistic for the second half of the year. We think that we're 8% to 10% within the highs of the year, and it looks to us like we may have some correction in the summer and early fall, before heading up to new highs as we approach yearend.

Q: How do you evaluate or rate generic-drug manufacturers when they have no pipeline?

A:

It's not so much the pipeline as it is what the current earnings are and how fast those earnings are likely to grow. Our favorite in that area is Mylan Labs (MYL ), which we have a strong buy on.

Q: Can you give us some names of S&P-rated companies with good cash reserves and still a reasonable share price? And good upside potential and no debt.

A:

Probably our favorite stock that meets that description is Microsoft (MSFT ). It has huge cash reserves, and we think a good price-appreciation potential.

Q: Lowe's (LOW ) or Home Depot (HD )?

A:

Our choice for the moment would be Lowe's. Sales have been rising at a double-digit rate, and we expect all of the mortgage-refinancing activity to continue to support home-improvement spending. We're currently neutral on Home Depot, where same-store sales have been a bit soft.

Q: Your opinion on Duke Energy (DUK )?

A:

We recently downgraded Duke's stock to an avoid after the sharp rise from its March low. We think the valuation is somewhat premium based on current balance-sheet strength.

Q: Can you give me your thoughts on Level 3 Communications?

A:

We currently have a sell recommendation on Level 3. We are frankly concerned about the company generating sufficient operating cash flow to service its speculative-rated debt.

Q: Another tech name here -- your thoughts on Cisco Systems (CSCO )?

A:

We have a strong buy on Cisco, and we see earnings back on the upswing, growing to 64 cents per share in fiscal 2004.

Q: Do you have other buys in tech? What's S&P's recommendation on weighting that sector in a portfolio?

A:

Our recommendation is to have a market weight in technology. Some of the other buys, in addition to Cisco, include Analog Devices (ADI ), Expedia (EXPE ), IBM (IBM ), Microsoft, Nokia (NOK ), Novellus (NVLS ), Sybase (SY ), and Texas Instruments (TXN ).

Q: What sectors do you now recommend overweighting -- and in which do you have the most strong buys?

A:

We're currently recommending an overweight position in consumer discretionary and in energy. We have the most strong buys in financials and health care, but only because those sectors are a much larger part of the overall market than [consumer] discretionary and energy.

Q: In the financials, your outlook for PNC Financial Services Group (PNC )? Is this a possible takeover candidate?

A:

We have an avoid recommendation on PNC. We're concerned about the recently announced deferred prosecution agreement with the Justice Dept. As a result, the company will take a $120 million pretax charge for the quarter endedyesterday. We currently view the stock as a below-average performer.

Q: So what are the strong buys in the financial group?

A:

We currently like Allstate (ALL ), AmSouth Bancorp (ASO ), Bank of America, Banknorth Group (BNK ), Capital One Finacial, Citigroup (C ), City National (CYN ), Commerce Bancorp (CBH ), Compass Bancshares (CBSS ), Hartford Financial Services (HIG ), IndyMac Bancorp (NDE ), Lehman Brothers (LEH ), MetLife (MET ), National Commerce (NCF ), Sovereign Bancorp (SOV ), Vornado Realty Trust (VNO ), and Washington Mutual (WM ).

Q: Over to the battered airlines, does AMR (AMR ) have more to go?

A:

Maybe. We recently upgraded AMR to hold. Their liquidity position has stabilized, making bankruptcy less likely. But we expect AMR in the near term to continue to lose money and continue to lose market share to better-positioned, lower-cost competitors.

Q: I have JDS Uniphase (JDSU ) and Oracle (ORCL ), both down about 50% since I bought. Sell or hold?

A:

Officially, we have a hold position on both stocks, but if you want to take the loss for tax purposes and reposition into some of the technology stocks mentioned earlier that we recommend, that may be an effective strategy.

Q: In the light of recent headlines, David, is it safe to buy Freddie Mac (FRE )? And while we're at it, what about Fannie Mae (FNM )?

A:

We like Fannie Mae and recommend accumulating it, even though there may be some increased government regulation in the wake of the Freddie Mac disclosures. We would avoid Freddie Mac, given the uncertainties of the pending investigations.

Q: How about Walgreen (WAG )?

A:

We currently like Walgreen and would recommend accumulating the shares. In their most recent report, comparable-store sales were up 8.2%, driven by a 12% rise in prescription sales. The company is still aggressively expanding and is set to open 425 stores this year and 450 stores next year. It expects to operate 7,000 stores by 2010.

Q: How will the legislation on prescription drugs affect pharmaceutical companies such as Pfizer and GlaxoSmithKline (GSK )?

A:

There's always some risk that legislation will cap a company's ability to recapture their R&D costs in the marketpace. But ultimately, we see the demographics favoring the large pharmaceutical companies. We recommend Pfizer with a strong buy, and we recommend holding Glaxo.

Q: What do you think of brokerage stocks such as Charles Schwab (SCH )?

A:

We are neutral on SCH, but have an accumulate recommendation on Merrill Lynch (MER ) and also an accumulate on Goldman Sachs (GS ).

Q: What energy stocks do you like?

A:

Our current favorites include Apache (APA ), Ensco (ESV ), Evergreen Resources (EVG ), Exxon Mobil, Global Santa Fe (GSF ), Nabors Industries (NBR ), Total (TOT ), and Weatherford International (WFT ).

Q: What do you think about Nextel (NXTL )?

A:

We have a strong buy on Nextel and see EPS of $1 this year and $1.30 next year. Favorable trends continue in subscriber retention and net subscriber additions.

Q: Is real estate still a place to be? REITs?

A:

We still like some REITs. However, we're somewhat less excited than we were several months ago because the dividends paid from many REITs will not enjoy the same tax treatment as dividends from industrial companies. Our favorite REIT at the moment is Vornado Realty Trust.

Q: There still seems to be some nervousness about improvement in corporate earnings -- what's your outlook?

A:

We see slow but gradual improvement as we approach the second half of the year, and by the fourth quarter, we, like most other market participants, are expecting strong double-digit growth. If that works out, we should have a good yearend rally and follow through into 2004.

Q: Small investors seem to be coming back into the market. Do you think this is a good idea now?

A:

Yes. Our current recommendation is for a typical investor to have 65% of his portfolio in stocks, 10% in bonds, and 25% as a cash reserve. So we continue to be still favorable long-term on the markets.

Q: With current interest rates, that means 35% of the portfolio earning very little -- if safe.

A:

That's true, but we are concerned about interest rates backing up next year. How about our 10 strong-buy stocks that could be the core of someone's portfolio? Those include American Standard, Bank of America, Boston Scientific, Capital One, FedEx), Fair Isaac, Lennar, PepsiCo, Pfizer, and Exxon Mobil. The end!

Edited by Jack Dierdorff

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