A Timely Sector Swap

S&P tells why it's boosting its recommendation on the Energy groupand downgrading its view on Consumer Staples

On July 16, S&P's Equity Strategy Group upgraded its recommendation to the S&P 500 Energy sector and downgraded its suggested weighting on the S&P 500 Consumer Staples sector. Here we'll take a look at the reasons for the moves and S&P's current outlook for each sector:

Energy Upgrade

S&P recommends overweighting the S&P 500 Energy sector. Year to date through July 13, the S&P Energy index, which represented 11.2% of the S&P 500 index, was up 24.8%, compared to a 9.5% gain for the S&P 500 index. In 2006 this sector index rose 22.2% vs. a 13.6% rise for the 500. There are seven sub-industry indexes in this sector, with Integrated Oil & Gas by far the largest at 62.6% of the sector's market value.

S&P equity analysts are positive on the fundamental outlook for the sector, reflecting expectations for continued strength in energy prices relative to historical averages. Global Insight projects West Texas Intermediate (WTI) oil prices remaining range-bound, averaging $62.08 per barrel in 2007. S&P analysts forecast that year-over-year gains in the sector's earnings per share growth will slow from 25% in 2006 to an estimated 3% decline in 2007, as EPS comparisons get tougher in light of record 2006 profit growth.

However we believe the sector's negative EPS outlook is offset by the second-lowest valuation in the S&P 500. Its price-to-earnings ratio on estimated 2007 earnings of 13.5 times is well below the 16.5 times p-e of the 500. Its p-e-to-projected five-year EPS growth rate (PEG) ratio of 1.2 times is below the market's PEG ratio of 1.4 times. This sector's marketweighted S&P STARS average of 3.7 (out of 5.0) is equal to the S&P 500 average of 3.7.

Technically, we are positive on the S&P 500 Energy index, which continues a fairly steep advance that started in March. While we believe the sector is overbought, it appears headed for additional gains. The sector is at an all-time high but we see no chart resistance to deal with. On a relative strength basis, energy has been in an uptrend since the beginning of the year, and is at an all-time high relative to the S&P 500. Weekly momentum is positive but has moved into overbought territory. Crude oil prices continue to work higher, and we think they could challenge 2006's all-time high of $77 per barrel.

In conclusion, we believe the sector's low valuation will likely expand as earnings estimates are revised higher amid continued elevation in energy prices. In our opinion, strong global energy demand is projected to continue— as a result of ongoing, better-than-expected, worldwide gross domestic product (GDP) growth, particularly in emerging markets—as rising per-capita incomes and urbanization lead to increased energy consumption.

We believe these developing economies are less fuel-efficient than developed markets, which increases their impact on oil and gas demand. On the supply side, we expect tight capacity to persist as output from the world's leading oil fields begins to decline. In addition, technological exploration and production (E&P) innovations may not be sufficient to offset stronger demand in the coming years, in our view. Lastly, we believe overweighting energy provides an efficient way to hedge the negative equity impact of any future escalation in global geopolitical conflicts.

Consumer Staples Downgrade

S&P recommends marketweighting the S&P 500 Consumer Staples sector. Year to date through July 13, this sector, which represented 9.2% of the S&P 500 index, was up 6.0% compared with a 9.5% gain for the 500. In 2006 this sector index rose 11.8% vs. a 13.6% rise for the S&P 500. There are 12 sub-industry indexes in this sector, with household products being the largest, representing 22% of the sector's market value.

S&P analysts' fundamental outlook for the sector is neutral. More specifically, we remain neutral on the influential household products and packaged foods and meats sub-industries, which together represent 36% of the sector's market cap. At a time when the U.S. economy is slowing, the sector's sizeable 40% international revenue exposure is allowing it to leverage ongoing robust European and Asian expansions.

Continuing commodity-pricing pressures are being offset by widespread corporate restructuring, in our view. In addition, an above-average, 2.3% dividend yield for the sector should support the shares, given that S&P expects more modest 2007 U.S. equity returns than the recent past.

The sector is trading at a p-e on estimated 2007 earnings of 18.6 times vs. 16.5 times for the broader market. Its p-e to projected five-year EPS growth rate of 1.8 times is higher than the market's 1.4 times, reflecting above-average EPS growth and revenue predictability, in our view. The marketweighted S&P STARS average of 4.1 (out of 5.0) for Consumer Staples is the highest in the S&P 500 and well above the index average of 3.7.

Our technical opinion on the S&P Consumer Staples Index is negative. The S&P Consumer Staples Index remains in an intermediate-term bullish channel after once again bouncing off the 17-week exponential moving average. While the trend remains higher, the sector has been underperforming the S&P 500 over the last year, and this weak relative showing has accelerated of late. The relative strength line is close to breaking below the April, 2006 low, which was the lowest since 2001.

We think that with the overall market breaking out to the upside, staples will continue to lag the S&P 500.

S&P Economics forecasts that the soft landing in U.S. real GDP growth has likely come and gone, alleviating the need for an increased exposure to defensive sectors of the equity markets. What's more, we believe higher average oil prices will likely maintain commodity cost pressures on forward earnings. The consumer staples sector is already trading at a valuation that is 16% higher than its normal premium valuation to the S&P 500 during the past 13 years.

As investors look over the market's &wall of worry& and begin to assign projected valuations based on an acceleration in economic growth in 2008, along with an improvement in operating earnings, we believe they will be less likely to embrace the slower, albeit more consistent, EPS growth typically seen in this sector.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of subindustries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).

Subindustry Company S&P STARS Rank Price (7/13/07)
Aluminum Alcoa (AA) 2 $47
Apparel, Accessories Quiksilver (ZQK) 5 $14
Commercial Printing R.R. Donnelley (RRD) 4 $45
Commodity Chemicals Lyondell Chemical (LYO) 3 $41
Computer Hardware Apple Inc. (AAPL) 4 $138
Construction & Engineering Jacobs Engineering (JEC) 5 $65
Construction & Farm Machinery Trinity Industries (TRN) 5 $46
Construction Materials Vulcan Materials (VMC) 2 $114
Diversified Metals & Mining Freeport McMoRan Copper (FCX) 3 $94
Fertilizers & Agr. Chem. Monsanto (MON) 3 $70
Footwear Nike (NKE) 4 $59
Internet Retail Amazon.com (AMZN) 2 $75
Steel Quanes (NX) 4 $54
Tires & Rubber Goodyear Tire (GT) 2 $36
Before it's here, it's on the Bloomberg Terminal.