OCTOBER 19, 2000
NEWS ANALYSIS
By Ken Shea, S&P
Amid the Turmoil, Opportunities for Smart Investors | If the S&P dips to 1300, a variety of quality stocks could make sense for buyers with a long-term view
| Investors have adopted a "sell first, ask questions later" attitude as market bellwethers Intel (INTC), Chase Manhattan (CMB), and IBM (IBM) have posted disappointing financial results. And things are being made worse by the surprisingly poor outlook reported by companies that depend on financing from -- or customers tied to -- the turbulent capital markets.
But market corrections like the sudden plunge witnessed Wednesday, Oct. 18 (though the Nasdaq and S&P 500 snapped back from the day's lows) are nothing new. It is important for investors to remember that such dips can often present opportunities for building long-term investment portfolios. Although I believe the major stock indexes still have some downside ahead, the near-term bottom for the S&P 500 index is probably near.
Over the past two months, S&P analysts have consistently trimmed their corporate earnings expectations, largely reflecting rising fears about the collective impact of higher energy prices, weakness in the euro relative to the U.S. dollar, and intensified price competition in the telecommunications sector.
BAD TIDINGS. The lowered expectations for earnings growth were confirmed by the recent dose of very poor third-quarter earnings pre-announcements. And now the other shoe has dropped: The forecasts are being borne out by a disappointing round of actual earnings reports. It was against this cloudy backdrop that the S&P Investment Policy Committee decided last month to reduce their recommended asset allocation of equities by 5%, to 60%.
What does S&P have to say about the current environment? At its current level of around 1345, the S&P 500 trades at approximately 23 times the forward 12-month operating earnings of $59 estimated by S&P equity analysts for the benchmark index. That represents a forward p-e multiple around 15% below the high reached earlier this year. Nevertheless, S&P recommends that investors remain cautious.
Here's a major reason why: The so-called Fed Model, the closely watched indicator of fair value for the S&P 500 index by the Federal Reserve, now suggests that the S&P 500 is still more than 25% "overvalued." That measure is based on past observations between the key variables of expected earnings and the yield on the 10-year Treasury note.
Specifically, the Fed Model calculation of forward 12-month operating earnings ($59) divided by the yield on the 10-year Treasury note (5.63%) computes a "Fair Value" of 1048 for the S&P 500. By this measure, the S&P 500 is now approximately 28% overvalued.
Investors should note that this level of "overvaluation" reached a pinnacle of 69% late last year. Many investors were able to rationalize that level by reasoning that the high-flying technology sector was becoming increasingly immune to macro-economic factors like a general slowdown in consumer and commercial spending for info tech products, or the impact of a weak euro. Based on recent events, these investors have evidently changed their minds.
TOP SECTORS AND STOCKS. Amid the gloom, what's an investor to do? Over the coming 6 to 12 months, S&P recommends that investors maintain a relatively conservative investment posture. We continue to recommend portfolio overweighting of the health-care and energy sectors; market-weight on capital goods, consumer staples, financial, technology, and utilities sectors; and underweight on the basic materials, communication services, consumer cyclicals and transportation sectors.
Let's get to some specific recommendations. The following stocks are all ranked by S&P analysts, meaning that they're expected to outperform the market over the next 6 to 12 months:
HEALTHSOUTH Corp (HRC)
Comcast (CMCSK)
Safeway Inc (SWY)
Nabors Industries (NBR)
Global Marine (GLM)
Citigroup Inc (C)
Tenet Healthcare (THC)
Dynegy Inc (DYN)
Long-term investors (whose time horizons are more than one year) should continue to position their investment portfolios to capitalize on four secular changes that will emerge in coming years: the globalization of commerce, the continuing spread of the Internet, the aging of the U.S. population, and the rising mobility of the U.S. population. Key stocks to benefit from these changes include:
Citigroup Inc (C)
Johnson & Johnson (JNJ)
Cisco Systems (CSCO)
Sun Microsystems (SUNW)
Medtronic, Inc (MDT)
Vodafone Group ADR (VOD)
Corning Inc (GLW)
A LITTLE PATIENCE. Did the markets touch bottom on Wednesday? We're probably close, but not quite there yet. It appears that Wall Street earnings-per-share estimates are still too high. Analysts are more likely than not to trim their forecasts as the next crop of earnings reports comes out. And many companies have used their third-quarter reports to lower expectations for fourth-quarter results. That could mean additional downside for the major averages.
But for long-term investors, such turbulence could ultimately present an opportunity. If we get another downdraft, and the S&P dips below, say, the 1300 level, it may be time to pounce on quality stocks like the ones we've listed above. Last time we checked, patience was still a virtue -- especially for investors.
Shea is director of equity research for Standard & Poor's
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Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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