Does Your Portfolio Need Health Care?

S&P explains why it upgraded its recommendation on this defensive sector to overweight and why it recommends moving away from more cyclical sectors

by Sam Stovall From Standard & Poor's Equity Research

52-Week Relative Strength—S&P Health Care Index

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On Jan. 9, Standard & Poor's Equity Strategy Group upgraded the S&P 500 Health Care sector, along with the Consumer Staples, Energy, and Utilities sectors, to overweight from marketweight. We also lowered our recommended holdings of Industrials (from marketweight) and Information Technology (from overweight) to underweight. They join Consumer Discretionary and Financial as sectors with the underweight designation.

As a result of S&P Economics' recently increased recession risk to 50%, combined with several U.S. equity benchmarks recently closing below their mid-2007 lows—implying to us that more downward price action is likely—we believe it is prudent to embrace a more cautious approach.

Health care has traditionally been one of the defensive groups investors turn to in dicey times. Year to date through Jan. 11, the S&P Health Care Index, which represented 13.0% of the Standard & Poor's 500-stock index, was up 3.4%, compared to a 4.6% decline for the S&P 500. In 2007, this sector index advanced 5.4%, vs. a 3.5% rise for the S&P 500. There are 10 subindustry indexes in this sector, with Pharmaceuticals being the largest, at 53.4% of the sector's market value.

Neutral Outlook

S&P analysts have a neutral fundamental outlook on the Health Care sector. Specifically, our outlook for the influential Pharmaceuticals subindustry is neutral, based on uncertainty regarding the impact of next November's elections, projected flat Medicare Part D volume, and relatively sparse R&D pipelines at major industry players. On the plus side, we think companies with well-defined growth prospects and generous dividend yields should hold up relatively well.

In addition, we are neutral on the biotechnology subindustry. While we see a lack of major product catalysts, and a more conservative Food & Drug Administration, those negatives should be offset by many novel therapies and strong patent protection. S&P analysts forecast 14% earnings growth for the biotechs in 2008. The sector trades at a price-to-earnings (p-e) on estimated 2008 EPS of 15.7 times, vs. 13.9 times for the overall market.

Its p-e-to-projected five-year EPS growth rate (or PEG) of 1.3 times is above the market's PEG of 1.1 times. This group's market-cap-weighted S&P STARS average of 3.8 (out of 5.0) is slightly above the average 3.7 for the S&P 500.

Switching to Defensive Sectors

Our technical outlook for the S&P 500 Health Care Index is neutral with a positive bias. The index remains in a longer-term uptrend and appears to be tracing out a fairly large ascending triangle formation, indicating to us prices will continue their long-term uptrend and break out to the upside. Prices are back above the 17-week exponential and 43-week exponential moving averages, a positive, in our view. Relative strength vs. the S&P 500 broke out to the upside in early November, which we think is a positive sign. Weekly momentum measures are bullish.

So there you have it. Increased recession risks and earnings that may not meet expectations are two of the reasons we believe investors should take a more defensive position. As a result, we recommend investors increase their exposure to traditionally defensive sectors such as health care, while reducing their exposure to the traditionally cyclical sectors. Some of our 5 STARS (strong buy) picks in the group include CVS/Caremark (CVS), Hologic (HOLX), and McKesson (MCK).

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).