"A Little Bumpy" on the Street

Joseph Lisanti of S&P's The Outlook sees inflation as one of the market's hazards, but still thinksstocks will end the year slightly higher

With the market beset by inflation worries, investors currently would do well to focus on higher-quality stocks, says Joseph Lisanti, editor of the S&P newsletter, The Outlook. And he adds that it would be wise to have a portion of a portfolio invested overseas as a hedge against a likely decline in the dollar.

Lisanti suggests information technology as a sector with some attractive stocks. In the broad tech area, he says S&P likes such names as Dell (DELL ), Automatic Data Processing (ADP ), Marvell Technology Group (MRVL ), Cree (CREE ), and McAfee (MFE ).

Broadly speaking, Lisanti notes that the S&P 500 index is off for the year. S&P thinks it will be a bit higher by yearend, he says, "but things are going to be a little bumpy along the road." One of the recent bumps he points to is the September jump in the producer price index, although S&P economists still think inflation will be "moderate by normal standards."

These were a few of the points Lisanti made in an investing chat presented Oct. 18 by BusinessWeek Online and Standard & Poor's, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat.

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

Joe, the market today offset some of the brief gains it made. How does S&P see the market now, and how has the 500 index been faring?

The S&P 500 is off for the year -- in fact, today it was off a full 1%. We think that by the end of the year, it will turn slightly higher, but things are going to be a little bumpy along the road.

"A little bumpy along the road"? What are some of the worries you have?

The main worry that the market has is inflation. Producer prices jumped 1.9% in September. That's the biggest jump since January, 1990, and well above the 1% rise expected by the market. Core PPI rose only 0.3%, not much higher than the market's expectation of a 0.2% gain. One factor that most people may not realize is that higher car prices pushed the core a bit higher than expected. Auto prices were higher because of the end of employee discount programs. Overall, our economists still see inflation as moderate by normal standards.

Another factor that ties into the inflation question is energy prices. The market has been worried about the latest hurricane in the Gulf, although it now appears as if the oil platforms and infrastructure will not take a direct hit. Assuming no other hurricanes or disruptions for political reasons, we expect crude oil to end the year at $62 a barrel and to be about $54 a barrel by the end of 2006. Even so, the bumpiness in energy prices and inflation numbers can set stocks back if we get a spike in either measure.

Q: How does S&P see the pharmaceutical sector now, and any of the specific stocks there?


Pharmaceutical stocks have been terrible performers for several years but recently have turned somewhat higher. Among our top picks in the group are AstraZeneca (AZN ), which we rank 5-STARS [a strong buy in S&P's Stock Appreciation Ranking System, known as STARS], and Teva Pharmaceutical Industries (TEVA ), also 5-STARS. Both of these are foreign companies that trade in this country as depositary shares or receipts. AstraZeneca is based in Britain, and Teva is based in Israel.

Last time I looked, S&P had General Motors (GM ) as a strong sell (1-STAR), but the stock bounced up after GM and the UAW agreed to scale back health benefits. Do you think this bounce can last?

Well, we are not that impressed with General Motors' deal with the UAW. Cash savings we estimate at about $1 billion per year, and although that's good news, the full benefits will not be seen until 2006 and could be partially offset by weaker sales volume and potentially higher costs from Delphi's (DPHIQ ) bankruptcy, in our opinion.

The potential sale of some GMAC assets would likely generate cash and lower borrowing costs, but it would cut income contributions to GM. We still rank the shares a strong sell.

How about tech stocks? Any good opportunities there now?

We like the technology sector at this point. We think there are a number of attractive opportunities in the group. In hardware, we like Dell (DELL ), which is ranked 5-STARS. Among data processors, our favorite large-cap play is Automatic Data Processing (ADP ), also ranked 5-STARS. Among semiconductor makers, our top picks include Cree (CREE ) and Marvell Technology Group (MRVL ), both of which we rank 5-STARS. In the software area, we like McAfee (MFE ), which is a play on the increasing need for Internet security.

Beyond Internet security, how do you view the Internet retailers and Internet advertising crowd? Companies like eBay (EBAY ) and DoubleClick (DCLK ), just to name two at random.

We currently rank eBay a hold (3-STARS), because we believe they paid too much for the telephony company Skype, and it doesn't fit the strategic needs of eBay's businesses. We also have a hold on Amazon (AMZN ), because we expect their sales growth to continue to moderate, reflecting a maturing core retail business. We do have a buy recommendation on Yahoo! (YHOO , 4-STARS). We project annual operating and net margins for Yahoo will widen in 2005 and 2006 as the company reduces costs and benefits from the integration of recent acquisitions.

In addition, we think the $3 billion stock repurchase announced in March, 2005, will bolster per-share earnings.

Do you like any video gaming stocks? Electronic Arts (ERTS ) or hardware makers like Sony (SNE ) with the holidays coming up?

We have a sell recommendation on Sony. The company indicated that earnings in fiscal 2007 (ending in March) will be challenging, with no revenue growth likely in electronics.

On the other hand, we have a buy recommendation (4-STARS) on Electronic Arts. We believe that the recent decline in the shares leaves them at attractive valuation levels. We believe the company will benefit significantly from the next generation of hardware consoles, and with strong franchises such as Madden NFL football, James Bond, Harry Potter, and Tiger Woods Golf, we believe Electronic Arts has the most diversified brand-name library in the industry.

Despite the market's problems, high valuations seem to be a continuing burden on some stocks. To what do you attribute that?

While some stocks may have rich valuations, overall the market is looking fairly attractive on a p-e basis. Remember that over the past five years or so, the S&P 500 has actually declined while earnings have soared. As a result, price-earnings ratios are now fairly moderate. Based on our estimate of 2005 operating earnings, the S&P 500 today trades at only 15.3 times earnings (that's as of the closing bell on Oct. 18). The average p-e since 1988 has been 19.8 times operating earnings. Consequently, we don't think the market is overvalued at this point.

Suitors seem to be swirling around AOL -- what's your view of the situation there and what it means for Time Warner (TWX )? (TWX, of course, is AOL's parent.) We like Time Warner, which we currently rank 4-STARS (buy). We do think that completing the deal for AOL, or a part of AOL, might be difficult because the content is very much tied to the Internet service provider business.

Most of the suitors, we believe, are interested in the content, but not the operation. We're not convinced that anything meaningful will happen with AOL in the near term, and Time Warner may want to hold on to the now more valuable content operations.

You mentioned that earnings have soared -- do you see that continuing in the current earnings report season, and beyond?

We are looking for 15% growth year over year in operating earnings in the third quarter. That's not much below the 17% gain that was posted in the third quarter of 2004. If earnings come in slightly better than we expect, that could provide a meaningful boost to stocks.

That said, earnings growth is decelerating, which is normal at this point in the economic cycle. We still expect earnings on the S&P 500 to continue to grow and look for a 10% gain for the full year 2006. While not as good as recent years, it's still an attractive number.

In the current climate, one can't resist asking about energy stocks and what might still look good there.

We currently have a market weighting on the energy sector. This is mainly because energy stocks have done so well thus far this year. Even so, there are a number of energy stocks that we still like. Among the major integrated oil and gas companies, our favorites include Exxon Mobil (XOM , a 5-STAR). We estimate Exxon's refineries' upgrading capacity (the ability to refine heavy sour crude) at 2.85 million barrels per day, about the largest in the world. With oil supplies tight, the ability to refine lesser grades of crude is an important one.

We also like some drillers, including GlobalSantaFe (GSF ) and Nabors (NBR ), both of which we rank 5-STARS. Among the refiners, we like Valero Energy (VLO ), also ranked 5-STARS.

And will consumer stocks be hurt by the impact of inflation, interest rates, and gasoline and home heating bills on consumers? At this point, it's hard to say. Clearly, lower-income individuals will be more hurt than middle-class and upper-income people, since a larger portion of their income will have to go to energy costs. But the U.S. consumer and U.S. industries are much more efficient in terms of energy than they were at the last oil crisis.

We spend far less of our GDP on energy than we did 20 or 30 years ago. In 1981, we spent about 14% of gross domestic product on petroleum, natural gas, and electricity expenditures. They now represent 8.7% of GDP. Keep in mind, too, that the base of American industry has changed dramatically since 1981.

Information technology constitutes more than 15% of the value of our index. Steel is 0.15%. The top four software and services companies in the U.S. had revenues of $124.4 billion in 2004; the four biggest American steelmakers had sales of $35.5 billion in the same year. The point is to remember that it takes much less energy to produce software than steel.

What economic indicators would you be watching most closely at this point?

At this point, we believe that the most important things to watch would be core consumer prices, consumer sentiment, and energy prices. All are related. If energy prices spike, and that seeps into the core consumer price index, consumer sentiment will take a nosedive.

Since about two-thirds of the U.S. economy is consumer-related, that would put tremendous pressure on GDP and on corporate profits. We think although there may be some pressure, it will be moderate. Consumers for the most part will continue to spend, and the economy will muddle through.

And what stance would you suggest for an investor looking for a place to put money now?

Right now, we think some of the information technology stocks are attractive.

We think higher-quality stocks are likely to do better in the months ahead for the reasons we outlined, and we think that investors should have a portion of their assets overseas. That would give them some protection against what we expect will be a declining dollar in the coming year.

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