Quality Matters

S&P thinks high-quality, large-cap names are the safest investments in a volatile market

The earnings reporting season has been filled with spectacular negative surprises -- General Motors (GM) missed consensus estimates by 1,800%, Sun Microsystems (SUNW) by 600%. Meanwhile, the S&P MidCap 400 and SmallCap 600 indexes continue to outperform the S&P 500 index of large-cap names.

Nevertheless, S&P continues to believe high-quality, large-cap names are the best place to invest.

Uncertainty about when the Fed will end its interest rate hikes raises questions about bonds. For that reason, equities remain the asset class of choice, in our view.

What's more, S&P equity analysts foresee an 11% year-over-year increase in operating earnings in 2006. Based on 2005 earnings, most of which are now "actual" since most companies have reported their fourth-quarter profits, the S&P 500 is trading at more than a 15% discount to the average trailing price-earnings ratio since S&P began tracking these data in 1988.

Even if we see further p-e contraction -- say, the current p-e of 16.7 times 2005 earnings contracting to 16 -- we still think 2006 will be a good year for equities. If we apply that multiple of 16 to the S&P analyst forecast of earnings of 84.82 for the S&P 500 index in 2006, we come up with a yearend price of 1357, close to our Investment Policy Committee target of 1360.

Although mid- and small-cap stocks are projected to post higher earnings growth than large-cap stocks in 2006, we think valuations are beginning to look stretched, as 2006 estimated p-e ratios for the MidCap 400 and the SmallCap 600 are in excess of 17, compared with a p-e of less than 15 for the S&P 500.

We advise a 45% weighting in U.S. equities. Our exchange-traded fund (ETF) portfolio calls for 35% in the S&P 500 SPDR exchange-traded fund (SPY).

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