Investors: Too Defensive, Too Soon


By Sam Stovall Has it been a year already? In March, 2003, the major indexes retested -- and held above -- the bear-market low of October, 2002. That important technical signal for the market helped convert many skeptics to the belief that, at the least, a new cyclical bull market was in the making.

Since then, as the table below shows, the S&P 500 has advanced nearly 40%. Of greater interest are the double-digit increases posted by the index's 10 sectors, from a low of just under 20% for health care to a high of 50% for financials. Indeed, of the 103 subindustry indexes in the S&P 500 that date back to Mar. 11, 2003, 101 posted advances: 91 with double-digit gains, and 10 with increases in excess of 100%.

However, the mood appears to be darkening a bit. Increasing concerns surrounding a possible Fed rate tightening, eroding consumer confidence, a still-weak jobs picture, the prospect of a victory by Sen. John Kerry in November, the recent stepup in terrorist activity, and the possibility of the current business cycle being less robust than hoped for appear to have added some bricks to Wall Street's fabled "wall of worry".

NOT PRESCIENT. Again, the table above indicates that investors have recently rotated into safe-haven consumer staples, dividend-rich telecommunications, and inflation-resistant energy issues. This appears to have left the economically sensitive industrials, information technology, and, to a lesser extent, consumer discretionary, and materials by the wayside.

So the question remains: Are rotation-happy investors prescient in piling into defensive segments of the market -- or premature? We at Standard & Poor's believe they're premature.

The Shift Is On

S&P Sector

% chg. 3/11/03-3/12/04

% chg. 1/30/04-3/12/04

Financials

50.5

1.3

Consumer Discretionary

50.0

0.4

Information Technology

49.0

-6.2

Materials

49.0

0.3

Industrials

42.5

-4.3

S&P 500

39.9

-0.9

Telecommunication Services

38.7

1.1

Utilities

37.6

0.5

Energy

29.6

3.2

Consumer Staples

25.9

3.8

Health Care

19.6

-2.3

To understand why, let's look at the interest-rate picture. Fed Chairman Alan Greenspan, in his address to the Economic Club on Mar. 2, admitted that the current spread between nominal (i.e., not adjusted for inflation) GDP and the Fed funds rate is abnormally wide by historical standards. And for a good reason -- the Fed has had many more opportunities to become proficient at fighting inflation than deflation.

LOUSY PREDICTORS. While Greenspan said rates would eventually rise, the timing of such a move went unstated. In our opinion, interest rates are likely to remain accommodative until inflation and employment heat up. In other words, we don't expect the Fed funds rate to start climbing until after the November Presidential election.

Even so, investors don't have a consistent track record of anticipating higher interest rates. There have been seven periods of rising interest rates since 1970 (see BW Online, 1/30/04, "Taking Cover from a Rate Hike"). The S&P 500 continued to climb an average 9% in the six months prior to the first rate hike, rising five times and falling twice. Yet six months after the Fed made its initial move, the S&P 500 fell four of seven times, for an average 4% decline. More compelling, however, is that only two industries in the S&P 500 posted average decreases before the first rate hike, while only one rose on average in the six months after.

Investors may also be overreacting to the current political climate. In our view, the stock market first indicated its concern with a possible change of Administration back in January, when Kerry won the Iowa Caucuses and New Hampshire primary. To many conservatives, his candidacy appeared to pose a more realistic threat to George Bush's reelection efforts than did Howard Dean's.

NOTHING TO FEAR? But do investors really need to worry about a Democrat in the White House? Not according to history. As can be seen in the table below, the S&P 500 has posted a greater average increase in the years that a Democrat was President than a Republican, and the market has suffered annual setbacks more frequently during Republican Administrations than during Democrats' tenures.

Donkeys, Elephants, and the S&P 500

% chg. under Dems.

% down yrs.

% chg. under Reps.

% down yrs.

Since '29

10.1%

30%

3.8%

40%

Since '45

10.7%

25%

7.6%

32%

And even if the Depression years were excluded, the Democrats still have the edge, mainly as a result of average first-year performances. The table below indicates that the S&P 500 actually declined, on average, during the first year of a Republican's term in office. And for good reason -- every Republican president since Warren G. Harding has had to deal with a recession during his first term in office.

The S&P 500's Performance

over a President's Term

Since '45

Year 1

Year 2

Year 3

Year 4

All times

5.4%

4.3%

18.0%

8.6%

Democrats

14.2%

1.6%

17.3%

9.7%

Republicans

-2.4%

6.6%

18.7%

7.5%

What about the effects of the 2004 election? One thing is clear: Wall Street doesn't like change and only tolerates uncertainty. Historically, when an incumbent has been reelected, the market breathed a sigh of relief by advancing 7.5%, vs. the 5.4% average increase during all first years. When an incumbent has been voted out of office, the market has not taken the change of Administrations very well, falling an average 4.7%. After nonincumbents battle it out, the market historically advanced by a subdued percentage.

S&P still believes George W. Bush will likely emerge victorious, but we expect the campaign to be a heated one, with rhetoric focused on jobs and taxes.

COMMUTING TO CHINA? This focus on the lack of job growth is possibly the main reason for recent investor concern. Had the February jobs report been stronger than anticipated, investors likely would have attempted to take profits in fear of a sooner-than-expected rate hike. But since the 21,000 increase in nonfarm payrolls for the month was sharply lower than anticipated, investors again headed for the exits, fearing that the still-weak jobs environment could precipitate a cascading decline in consumer confidence, consumer spending, and capital investment, further impacting corporate hiring plans.

Should consumers fear that their jobs are headed overseas? Or that white-collar workers soon will be commuting to India or China? Not necessarily, according to the U.S. Labor Dept., unless those workers are employed in the education services, manufacturing, or natural resources sectors. Take a look at the table below, which shows historical and projected growth in domestic employment.

10-Year Changes in Employment Growth

Employment Sector

1993-2003 (mil.)

2003-2013E (mil.)

1993-2003 (%)

2003-2013E (%)

Total Non-Farm

18.1

16.8

16.2

12.9

Prof. & Bus. Svcs.

4.4

5.1

37.6

31.6

Health Care

3.3

2.8

30.9

19.8

Construction

1.9

2.1

38.3

30.3

Transportation

0.6

1.5

15.9

34.8

Leisure & Hospitality

2.3

1.4

23.2

11.4

Government (Fed. & Local)

2.5

1.2

13.0

5.6

Finance

1.2

0.9

17.4

11.1

Wholesale

0.5

0.8

9.0

13.9

Info. & Publishing

0.5

0.6

18.1

18.7

Retail

1.8

0.3

13.5

1.8

Utilities

-0.1

0.0

-17.6

0.3

Educational Services

0.9

0.0

51.2

-0.5

Natural Resources

-0.1

-0.2

-14.3

-27.1

Manufacturing

-2.5

-0.4

-14.7

-2.7

At first glance, one might be a bit concerned that the average monthly increase in jobs will decline from the roughly 150,000 pace during the past 10 years to about 140,000 per month over the coming 10 years (S&P's estimate is even more conservative than these Labor Dept. figures). But David Wyss, S&P's chief economist, reminds us that if you factor in the gradual retirement of baby boomers over the coming years, the projected growth in jobs is expected to keep the unemployment rate steady at the 45-year average of 5.5%.

A VOTE FOR STOCKS. With all the concerns about the Fed, the jobs picture, the election, etc., stock prices have moved dramatically lower in March. All the same, S&P still believes that equities offer a more attractive risk-adjusted return than bonds or cash. What's more, corporate earnings, as seen in the table below, are projected to advance 15% in 2004, led by surges in technology, materials, health care, and consumer-discretionary issues.

Operating EPS % Changes, Year-over-Year

S&P 1500 Sector

2004E

Information Technology

58

Materials

57

Health Care

26

Consumer Discretionary

21

Industrials

15

S&P 500

15

Financials

9

Consumer Staples

3

Utilities

1

Telecommunication Services

-2

Energy

-6

S&P's Investment Policy Committee has maintained its year-end 2004 target of 1,230 for the S&P 500, representing an 11% increase from the 2003 closing level of 1,111.92. Where should investors focus for the rest of the year? Our distribution of stocks with our top investment ranking of 5 STARS (buy) continues to show that our analytical team favors overweighting the consumer discretionary, health care, and technology sectors. Stovall is chief investment strategist for Standard & Poor's


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