Behind S&P's Sector Strategy Shifts
S&P's Investment Policy Committee voted on July 7 to reduce its yearend target for the S&P 500 index to 1,390 from 1,490. The committee cited a lengthening of the projected recession (David Wyss, S&P's chief economist, is calling for a shallow downturn that should last 16 months, or six months longer than the average recession since World War II), a continued erosion of S&P equity analysts' estimates of S&P 500 operating earnings, and an increase in our forecast for oil prices.
Influenced by the lower yearend target price, as well as sector-specific fundamental and technical considerations, S&P's Equity Strategy group raised the recommended weighting of the S&P Health Care and Utilities sectors to Marketweight from Underweight. At the same time, it reduced the recommended exposure to the Consumer Discretionary and Industrials sectors to Underweight from Marketweight.
We upgraded the S&P 500 Health Care sector because we believe a prolonged period of underperformance reflects the fact that investors have already factored in many of the group's fundamental headwinds. With equity volatility likely to remain elevated and much of the bad news already reflected in share prices, we think investors will refocus on Health Care's defensive qualities, which will allow for better relative performance. The group is currently trading at 13.7 times 2008 estimated earnings per share, a discount to the S&P 500's multiple of 14.4. In addition, the sector sports a healthier profit outlook, with 2008 EPS projected to rise 11%, vs. 6.4% for the 500 index.
We upgraded Utilities in light of the group's traditionally defensive characteristics, combined with S&P equity analysts' anticipated 12% growth in utilities' EPS vs. a 6.4% rise in EPS for the S&P 500, and the sector's above-average 3.2% dividend yield. Yet we chose not to recommend overweighting the sector, because of its price-earnings ratio of 15.4 times 2008 estimates, vs. 14.4 for the S&P 500, since the group normally trades at a substantial discount to the overall market.
We downgraded the S&P Consumer Discretionary sector, as we expect growth in consumer spending to slow to 0.3% in 2009, from 1.7% projected growth this year and a 2.9% rise in 2007. Operating EPS for the sector is forecast to decline 2% in 2008, compared with an expected rise of 6.4% for the S&P 500. Despite a year-to-date price decline of 15% for the sector index through July 3, the p-e ratio on projected 2008 operating earnings was 16.9 times, versus the S&P 500's 14.4. Higher energy prices, lower consumer confidence, and eroding EPS estimates give us little reason to believe this group will stage a sustainable rally.
Finally, we downgraded the S&P 500 Industrials sector. With the U.S. economic slowdown expected to accelerate and midcycle slowdowns under way in Canada, Japan, Britain, and the rest of Europe, we believe this cyclical sector is vulnerable to shrinking p-e's as investors question the group's future EPS growth. We also believe accelerating emerging market (EM) inflation and central-bank rate increases in BRIC (Brazil, Russia, India, China) countries are making investors increasingly worried that EM economic growth will begin to decelerate. S&P analysts currently forecast a 5% gain in EPS for Industrials this year, below the 6.4% projected for the S&P 500. In addition, earnings visibility for the group is low.
So there you have it. We have reduced our yearend target for the S&P 500—and altered our sector recommendations—as a result of the rising risks we see for equity prices. Despite the reduced yearend target price, the Investment Policy Committee did not alter its recommended asset allocation, which remains at 45% U.S. equities, 15% international stocks, 25% bonds, and 15% cash. The 1,390 target, while 5% below last year's close of 1,468, is nearly 10% above the July 3 closing level of 1,263.