Preparing for a Slower Second-Half

Peter Wall of Chase Personal Financial Services sees market gains in 2004's first half. After that, the outlook gets cloudy

The stock market giveth, and the stock market taketh away. After gaining as much as 4% by mid-February, the benchmark Standard & Poor's 500-stock index is now pretty much back where it started at the beginning of 2004. The main culprit is the nation's crummy jobs outlook, which has investors questioning the strength of the U.S. recovery. But also to blame, especially for recent selling, is the linking of the deadly bombings in Madrid on Mar. 11 to Islamic militants. If one thing's certain about the market, it's that investors hate uncertainty.

Another sure thing, according to one investing pro: Stocks aren't going to come anywhere near matching last year's run. That's the forecast of Peter Wall, who oversees investment policy at Chase Personal Financial Services, a unit of JP Morgan Chase, as well as investment policy and product research for consumers and small businesses with between $250,000 to $10 million to invest. New York-based Wall believes his clients can outperform the market by focusing on several key sectors that are expected to do well in this challenging environment. Recently, Wall chatted with BusinessWeek Online reporter Eric Wahlgren about his expectations for equities and the economy, as well discussing his investment strategy and hot-sector picks. Edited excerpts of their conversation follow:

Q: What happened to that feel-good sentiment investors had at the start of the year?


Investors are skittish about the economy and about how economic growth will be sustained. That stems from the jobs numbers more than anything. It has a major psychological impact on clients. We have seen that nervousness reflected in the consumer-confidence and consumer-sentiment numbers.

Q: How do you see stocks behaving in the rest of 2004?


Our expectation is that corporate earnings will rise in the 8% to 10% range overall for companies in the S&P 500. What that means in terms of our expectations for the market is that the S&P 500 will gain about 7% to 10% this year. We think a lot of those gains will occur in the first half of the year.

Q: Why would the advance be mainly in the first half?


Most of the corporate earnings growth will happen in that time frame. What we're expecting in the second half of the year is a slight pullback in the market. That's because we think the economy will be growing sufficiently for the Federal Reserve to increase interest rates in the November time frame. But we don't think the Fed will need to raise interest rates until after the election.

With rising interest rates and earnings disappointments -- we think profit expectations are overstated for the second half of the year -- we will likely see a pullback in the second half.

Q: The market fell on Mar. 15, after news that train bombings in Madrid were linked to terrorist group al Qaeda. Has it influenced your outlook on the market?


At this point, unless there's a trend of more terrorist attacks, which would surely have an adverse effect on the market, we look at what happened [in Spain] as something that won't have a long-term effect. Any action we've seen this year [in the market] is really more related to the economy and jobs. Our outlook going forward hasn't changed. We still think the U.S. economy is on solid footing. But if terrorist attacks become more consistent, that will change our outlook, certainly.

Q: What are you advising your clients right now?


Overall, our asset-allocation models are a little more weighted in equities than fixed-income. We're roughly at 65% stocks and 35% bonds. If you look at your alternatives, the equities market is still your best bet. The yield on bonds is 3% to 4%. You can have a better return on some high-dividend yielding stocks.

Q: What sectors do you like?


We're overweight in four areas: health care, energy, basic materials, and industrials and transportation. In health care, we feel companies have an attractive relative-earnings momentum. We look at the year-over-year earnings-growth expectation of a sector, vs. the overall earnings-growth expectations of the market. If that number is a larger number, it's a good indication of good earnings momentum.

Health care is also a good demographics story. Health care is going to be more and more a part of an individual's personal spending. New drugs are going out on the market. There don't seem to be any major litigation issues right now, so we're looking at a good regulatory environment.

Q: What about energy?


Energy is favorably valued. This is more of a cyclical play for us. We continue to see global economic growth, particularly in the Far East. China and Japan are major consumers of oil. In China, we're expecting growth in the 8% to 10% range this year. We think there's going to be a lot of demand for energy in the U.S. and overseas.

As for basic materials, such as paper goods, and industrials and transportation, we are seeing a pickup, as these are the bare essentials that benefit from economic growth.

Q: What are you avoiding?


We're underweighting tech and telecom. We feel that the valuations on the tech side have gotten a little high. As for telecom, there's still a lot of disarray in the industry. There's still a lot of restructuring and consolidation that needs to be done. We're recommending that clients stay away from telecom for now.

Q: Will you be changing any of your sector weightings if a Democrat wins in November? The current Administration is known for its friendly policies toward the energy industry.


It's unlikely we would change our weightings on a Democratic win. It may change our overall equity vs. bond weightings. We want to see more clarity on plans for health care.

Q: What else are you looking at right now?


We're concerned about a light resurgence in inflation. We're seeing a situation that is not dissimilar to the late '60s, during which we had a very accommodative monetary policy. We have a budget deficit and a trade deficit. We're starting to tell clients to gradually ease into investment strategies that might provide a hedge against inflation. Inflation could rise to 2% to 2.5% next year from about 1.6% this year.

On the bonds side, investors may want to consider purchasing Treasury Inflation Protected Securities [TIPS]. Roughly 10% to 15% on the bond portfolio could probably be in TIPS. On the equities side, we may tell clients to invest more in real assets such as real estate or commodities. We're not there yet. But we have cautioned clients about inflation.

Q: It sounds like investors shouldn't expect the market to match the gains of 2003, right?


Last year, you had a situation in which the market was undervalued, given an economic recovery. The market is fairly valued at this point. We have a situation where we have moderate growth in the economy.

Q: Speaking of the economy, what do you expect it to do this year?


Right now, we expect gross domestic product to grow at a healthy [annualized] pace of 5% for the rest of the first half of the year. That reflects spillover from the stimulus we've been seeing from [Bush's] tax cuts and low interest rates. Coupled with that, we are seeing continued increases in productivity and corporate earnings coming out really strong.

What the economy will need for sustained growth is an increase in wages and salaries, which is directly related to hiring. All the economic growth has really been driven by consumer spending. We are starting to see a pickup in business investments.

Q: If hiring is crucial to keeping this economy humming, when will we see it?


We're starting to see indications that businesses will hire. I really see it happening in the second half of the year. To date, businesses have had a strategy basically of leveraging the existing workforce as much as they can. The increase in the productivity numbers has reinforced the belief held by a lot of business owners that they can get more mileage out of the existing workforce.

Hiring is always a lagging indicator. It's the investment that is the most difficult to disinvest from [for businesses]. People don't want to hire until they are really clear that they need the employees. We're getting to the point that companies are going to have to start making some changes. We have seen some big rises in temporary employment in the last few months. That's an indication that firms have really reached the max in terms of relying on existing workforces.

Edited by Beth Belton

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