business

No Firming on Earnings

Joseph Lisanti of S&P's The Outlook newsletter reports that only industrials and health care now get an overweight rating

There are only two sectors of the stock market that Standard & Poor's currently recommends investors overweight in their portfolios: industrials and health care. That's the word from Joseph Lisanti, editor of the S&P newsletter The Outlook. However, he notes that in health care S&P isn't recommending the large pharmaceutical companies, which make up the biggest portion of the sector; its favorable opinion applies to HMO, hospital, and medical-device operations.

Despite recent softness in stocks, Lisanti says S&P still expects the 500 index to reach 1300 by yearend, in large part because it predicts that corporate earnings will hit a new record in 2005, with a 10.4% increase, even though earnings growth has been slowing down. And he also thinks the market will become more comfortable with the Federal Reserve's gradual increases in interest rates. S&P also expects the price of oil to stabilize, Lisanti adds.

Partly reflecting the market's behavior, S&P has recently suggested that investors cut the percentage of their portfolios in U.S. stocks from 45% to 40% and increase the foreign-stock portion from 15% to 20%, Lisanti says, with 25% in short- to intermediate-term bonds and 15% in cash.

These were some of the points Lisanti made in an investing chat presented on Apr. 19 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. AOL subscribers can find a complete transcript at keyword: BWTalk.

Note: Joseph Lisanti has no ownership interest in or affiliation with any of the companies under discussion in this chat, except as noted.

Q: Joe, what do you make of this market? Do you think the Dow will reach 11,000 by yearend? Or the equivalent on the S&P? Too optimistic?

A:

It's a difficult market. We think that what we have seen is a deterioration in all of the major indexes, resulting in new lows for 2005. Today, we did see a reversal on good volume, but we really don't think this is the start of a move to new yearly highs.

We don't usually forecast the Dow, but we do think the S&P 500 -- now at a little below 1153 -- could reach 1165 to 1170 on this bounce. Mark Arbeter, our chief technical strategist, believes that at that point we may see a retest of the lows. Ultimately, S&P's investment policy committee sees the S&P 500 ending the year at 1300.

Q: When will the markets behave normally?

A:

That depends on what you mean by "behaving normally." Stocks often react to events, and the events that are driving this market can have an effect on the economy. For example, if oil prices were to spike, that would depress economic activity and contribute to inflation. If suddenly foreign governments stopped buying our Treasury debt, we would suffer a potential financial crisis.

Q: What driving forces do you foresee bringing the S&P 500 to the yearend level you mentioned [1300]?

A:

We think there are a number of factors that will cause stocks to rise by the end of the year. In particular, we continue to believe that earnings on the S&P 500 will hit a new record this year. Although earnings growth has decelerated, we still look for a 10.4% gain in operating earnings over last year. In addition, we think that the market will become more comfortable with the Federal Reserve's efforts to move the Fed funds rate from stimulative to neutral.

David Wyss, S&P's chief economist, thinks that means a Fed funds rate of 4% to 4.5% by yearend. We believe that that will neither stimulate nor depress the economy, and that it remains low enough for continued good economic growth in the U.S. One last factor is we believe the price of oil will stabilize. We are not in the camp that is predicting $100-per-barrel oil. We think oil will gradually decline over the next two to three years.

Q: Four years ago I bought Watson Pharmaceuticals (WPI ), at that time highly touted by your newsletter, The Outlook. What are your thoughts on that?

A:

We currently have a 3-STARS (hold) recommendation on WPI. We think the company's pipeline of 34 drugs is promising, that their cash flow is strong, and that 2005 is likely to be a transition year. Keep in mind that the entire pharmaceutical group has been under tremendous pressure. And that has weighed on WPI, as well as other members of the industry. For now, we recommend holding WPI.

Q: What are your thoughts on Bank of America (BAC )?

A:

BAC rates a strong buy from S&P. We thought their first-quarter conference call was upbeat and provided no major surprises. We think they will become more efficient in 2005, as BAC realizes further expense savings from the integration of Fleet. Our current target price is $54.

Q: What are your thoughts on Citigroup (C ) and its low p-e ratio?

A:

We continue to like Citigroup, which we currently rank a strong buy (5-STARS). First-quarter operating earnings came in at $1.04 -- 2¢ above our estimate. Strong consumer business globally, and lower credit losses, offset the negative effect of rising short-term interest rates and soft equity markets.

We think that C should sell at about 12 times our 2006 earnings estimate of $4.75, for a target price of $57. The 12 multiple would put Citigroup in line with its peers.

Q: While we're on financials, how do you see JPMorgan Chase (JPM ) faring in the coming months?

A:

First, a disclosure: I own shares of JPM. Our analyst currently ranks the stock 4-STARS (buy) and describes JPM as "a work in progress." We think management is both capable and determined to create a more efficient and diversified business model with improved earnings consistency. However, we believe earnings are likely to remain volatile in the near term. Our 12-month target price of $43 assumes that JPM will trade at a multiple in line with its peers.

Q: What are your thoughts on eBay (EBAY )?

A:

We currently have a 3-STARS (hold) opinion on eBay. We believe the recent decline was due to concerns about first-quarter results. EBay's recent replacement of its boutique ad agency with the larger BBDO Worldwide suggests to us that its disappointing fourth quarter was related in part to its advertising strategy. We recently cut our target price for the stock to $40, from $46.

Q: Do any Internet-related stocks look good at the moment?

A:

In the Internet software and services industry, we currently like ValueClick (VCLK ) [as a 5-STAR strong buy]. It provides products and services that enable marketers to advertise and sell their products through all major online marketing channels.

In the same industry, we like WebEx Communications (WEBX ), which is also ranked 5-STARS. We think WebEx is gaining share in the high-growth market for on-demand Web conferencing. We currently have 4-STARS (buy) recommendations on two familiar names --- Google (GOOG ) and Yahoo! (YHOO ).

Q: Any hope for U.S. autos? What about Ford (F )?

A:

We currently have Ford ranked 2-STARS (sell). We cut our 12-month target price to $9, from $12. We're concerned about management's ability to forecast performance. We expect the company to cut costs more aggressively, but we see sales and margin pressure in 2006 in the important light-truck/SUV category. Lastly, we see Ford's annual 40¢-per-share dividend at risk for reduction.

General Motors (GM ) we also rank as 2-STARS (sell). We think GM's cash dividend could be cut 50% to conserve cash.

Q: What do you think about shares of Lowe's (LOW ) home-improvement stores? And Home Depot (HD )?

A:

We currently have Lowe's ranked 4-STARS (buy). The shares traded a bit lower after the company's earnings guidance for fiscal 2006 was a bit disappointing. Nevertheless, based on discounted cash flow analysis, we still think the stock is attractive, and we have a target price of $65.

Home Depot (HD ) we also rank 4-STARS (buy). The company recently increased its cash dividend and authorized an additional $2 billion to to repurchase shares. Our 12-month target price for HD is $48.

Q: Technology and communications have had a rough time in this evolving market. What does the future look like?

A:

We currently recommend a market-weight approach to the information technology sector, which has been very weak recently. We have an underweight recommendation on telecommunications services. We already mentioned a few technology stocks in the Internet area that we favor. We also like EMC (EMC ) in computer storage. We like Automatic Data Processing (ADP ) in the computer-services area as well.

In the telecommunications area, we would be very selective. We like CenturyTel (CTL ), which we rank 5-STARS. Among the larger service providers, we like Verizon Communications (VZ ), which we rank 4-STARS. Among wireless companies, our favorites include Nextel Communications (NXTL ) and Nextel Partners (NXTP ), both of which are ranked 4-STARS.

Q: Speaking of weightings, do any sectors get better than a market weight now?

A:

Yes, but not many. The only sectors that we currently recommend investors overweight are industrials and health care. And we should explain that our overweight in health care is a bit unusual. Large pharmaceutical companies are the biggest factor in the health-care sector. Even so, we don't currently recommend large pharmaceutical companies. Our overweight in health care reflects our favorable opinion of companies in the HMO, hospital, and medical-device industries.

Q: Any favorites in energy? Will intermediate domestic oil companies outperform the mega-majors?

A:

That's a tough question because it depends on what happens in the near term with the price of oil. Some of the smaller companies that we like in oil and gas exploration and production include Devon Energy (DVN ), which we rank 5-STARS, and Forest Oil (FST ), which we rank 4-STARS. Among the giants, we like Exxon Mobil (XOM ), which is ranked 5-STARS; Total (TOT ), a European integrated oil company that we also rank 5-STARS; and ChevronTexaco (CVX ), which we rank 4-STARS.

The advantage of the giant integrated oils is that they can make money even when oil prices decline because they have huge refining and marketing operations. If oil prices were to rocket higher, some of the pure-play producers would probably do better. We expect that oil prices will be fairly stable around the $50-per-barrel level, although you will see volatility in the oil price from time to time. Under current conditions, we think most oil producers and integrated oil companies should show good profits.

Q: Given the market's behavior, has S&P made any recent changes in its recommended asset allocations?

A:

We did about a month ago lower our allocation to U.S. stocks, from 45% to 40%. At the same time, we raised our foreign stock allocation to 20%, from 15%. For those investors who use exchange-traded funds to track our recommended asset allocation portfolio, we placed the 5% in the iShares S&P Europe 350 Fund (IEV ).

We believe that this move will capture what we expect to be another downward leg in the bear market in the dollar. The S&P Europe 350 Fund has had a one-year total return of 18.8% through Apr. 14.

Q: How would you allot the remaining 40% not taken up by U.S. and foreign stocks?

A:

The remainder of our allocation is 25% in bonds -- mainly short- to intermediate-term -- and 15% in cash. If you're using exchange-traded funds, we would break that down to 15% in the iShares Lehman Aggregate (AGG ) and 10% in the iShares Lehman 1-3 Year Treasury (SHY ).

Q: Is your allocation the same for retirees?

A:

This is a general allocation, and we don't specifically target it to retirees or working individuals. Keep in mind, however, that retirees generally need more income from their investments and still need some protection against inflation via capital appreciation.

For that reason, we would suggest that retirees include dividend-paying stocks, particularly stocks of companies that increase their dividends regularly, in the equity portion of their portfolios.

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