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JULY 18, 2006

Sam Stovall's Sector Watch

By Sam Stovall

Time to Play Defense

The watchword for investors is caution as S&P lowers yearend expectations for the S&P 500 due to low earnings growth, the Fed, and oil

From Standard & Poor's Equity Research
In my opinion, a strategist doesn't add value if he is a perennial bull. Sometimes it's prudent to take a cautious stance.

S&P's Investment Policy Committee (IPC) and Equity Strategy Group believe that embracing a bit of cautiousness during this seasonally weak period is a wise move. On July 12, S&P's IPC voted to lower its yearend 2006 target for the S&P 500 to 1,315 from 1,385. We now expect the 500 to post a full-year price advance of 5%, vs. our earlier estimate of 11%.

What's behind the move? We believe the primary risk to second-half price appreciation lies with sub-10% growth in second-quarter earnings projected by S&P analysts for the S&P 500, combined with the possibility that second-half earnings-growth estimates will need to be lowered, as a result of an overly aggressive Fed, stubbornly high oil prices, and a rapid deceleration in estimated real GDP growth.

Consistent with this downward adjustment in our yearend target, S&P's Equity Strategy Group raised its recommended weighting for the S&P 500 Consumer Staples sector to overweight from marketweight, and lowered its suggested exposure to the S&P 500 Information Technology sector to underweight from marketweight (see BusinessWeek.com, 7/13/06, "S&P Cuts IT Sector, Boosts Consumer Staples").

TECH'S DOWNWARD TREND.  Of course, Consumer Staples is a classic defensive group. Given inelastic demand for many of the products sold by companies in the sector, we believe it will continue to benefit from the current "flight to quality" in the U.S. equity market. The sector has the highest S&P Quality Ranking—a measure of long-term earnings and dividend growth—in the S&P 500 index, with 77% of its universe ranked A- or higher.

On the flip side, the Tech sector's 2006 operating EPS growth is projected at just 4%, vs. 12% for the S&P 500. Yet this cyclical sector's price-earnings on estimated 2006 operating EPS continues to trade at a 31% premium to the 500's ratio of 14.9 times.

The Tech and Staples sectors have the lowest correlation among the 10 sectors within the S&P 500. The chart below illustrates their price movement relative to the S&P 500 on a rolling 12-month basis for both sectors, with Staples now outperforming and gaining strength, while Tech continues the downward trajectory begun earlier this year.


Source: Standard & Poor's

In summary, S&P believes that rising concern over what we call the Trio of Trepidation (oil, rates, and earnings) should not be ignored and may even push U.S. equity markets into the long-overdue correction phase within a bull market. We favor those sectors with high S&P Earnings & Dividend Rankings (Consumer Staples and Financials), as well as the Energy sector, since heightened geopolitical risk will likely raise oil prices, and increase earnings visibility for energy issues. However, we believe the high-beta, consumer-dependent Consumer Discretionary and Information Technology areas are vulnerable to an overly aggressive Fed and a resulting slowdown in economic and EPS growth.

Industry Momentum List Update
For regular readers of the Sector Watch column, 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 the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry	Company	S&P STARS	Price (7/14/06)
Agricultural Products	Archer-Daniels-Midland (ADM )	4	$42
Air Freight & Logistics	FedEx (FDX )	5	$109
Coal & Consumable Fuels	Massey Energy (MEE )	4	$32
Construction & Engineering	Jacobs Engineering (JEC )	5	$74
Diversified Metals & Mining	Phelps Dodge (PD )	4	$80
Fertilizers & Agricultural Chemicals	Monsanto (MON )	2	$83
Gold	Newmont Mining (NEM )	4	$55
Human Resource & Employment Services	Robert Half Intl. (RHI )	5	$35
Oil & Gas Equipment & Services	Baker Hughes (BHI )	4	$84
Oil & Gas Refining & Marketing	Valero Energy (VLO )	5	$65
Railroads	Burlington Northern Santa Fe (BNI )	4	$73
Steel	Carpenter Technology (CRS )	4	$108

Stovall is chief investment strategist for Standard & Poor's Equity Research Services