A GOP-Inspired Relief Rally


By Sam Stovall The voting has ended, and President Bush has won reelection -- and by all appearances, with a margin of victory that ensures credibility of the final result. More than 110 million Americans voted on Nov. 2, making it among the largest turnouts in 40 years. What's more, not only have both houses of Congress remained Republican, but each has also seen an increase in its Republican majority.

What should investors look for now that the dust has settled? We at Standard & Poor's think the stock market is likely to experience a near-term relief rally, as a result of the apparently quick resolution to the election, and the absence of a repeat of the difficulties that marred the 2000 contest. We think the S&P 500 stock index, which closed at 1,130 on Tuesday, Nov. 2, will meet, and possibly exceed, our Investment Policy Committee's yearend target of 1,150.

WORRISOME FUNDAMENTALS. The benchmark index's advance should be led by gains in those industries that were projected to be pressured by a possible Kerry victory: Dividend-paying issues, along with major pharmaceuticals, managed care, textile manufacturers and importers, and information-technology companies with a significant offshore presence, just to name a few. Meanwhile, defense contractors, energy companies, and selected financial outfits are likely to experience a firming of their share prices.

Once the relief rally has run its course, however, investors will have to shift their attention back to the fundamental economic backdrop, in our view. The budget deficit remains the largest in history (in nominal terms) and likely precludes further fiscal stimulus from Washington. In addition, we see the value of the U.S. dollar continuing its slide vs. other major currencies in response to the enormous trade deficit. During the coming four years, we think President Bush, like President Reagan in his second term, will have to turn his focus from recovery to reform of three thorny policy thickets: the tax code, tort liability, and health care.

On a sector basis, we remain cautious about the longer-term prospects for the major pharmaceuticals, despite a possible near-term rally. We believe companies in this group will experience an increase in litigation in the months ahead, as a result of recent product recalls and FDA scrutiny. We think new drugs are likely to undergo extended trials, while existing compounds may be required to undergo retrials.

DEFENSE STOCKS? Moreover, we believe drug company new-product pipelines remain thin by historical standards and are not sufficient to offset looming patent expirations. Even though valuations may look appealing to some investors, we don't expect the group to see capital inflows anytime soon. We currently have only one major pharmaceutical company with our highest investment ranking of 5 STARS (buy): Johnson & Johnson (JNJ

; recent price, $58). However, we still have 5-STAR rankings on 13 issues in other health-care subindustries such as biotechnology and medical devices.

One other sector recommendation may seem counterintuitive. Despite the Bush victory, S&P suggests avoiding most defense stocks. We think many defense shares are trading at or above multiples to their sustainable earnings growth and profitability potential. We think the probabilities of modest long-term U.S. defense-budget growth, intense competition, accelerating product substitution, and the government's dominance in dictating price and terms should keep sustainable EPS growth of many big defense contractors in the 5% to 7% range, with expected return on equity in the 10% to 15% range. Both those ranges are well below the current price-earnings multiples of 17% to 20%-plus for group members.

In general, we forecast single-digit returns from the S&P 500 in 2005 and recommend a balanced investment allocation. We suggest the average investor have 45% in domestic equities, 15% in foreign issues, 25% in short-term bonds, and 15% in cash. We suggest a focus on high-quality issues across the market-cap and growth/value spectrum.

Of the 110 companies on our 5-STARS list, all 10 sectors are represented. More than 50% of these companies have market values below $10 billion, and 73 pay a dividend.

On a sector level, we currently have overweight recommendations on the energy and telecommunications-services sectors. Some of our 5-STARS picks in these groups include ExxonMobil (XOM

; $49), ChevronTexaco (CVX

; $53), and Apache (APA

; $50), among the energy issues; and Alltel (AT

; $55), Nextel Communications (NXTL

; $27), and Verizon (VZ

; $41) in telecom services.

Required Disclosures

Standard & Poor's Stock Appreciation Ranking System (STARS)

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate that of the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of Sept. 30, 2004, SPIAS and their U.S. research analysts have recommended 29.2% of issuers with buy recommendations, 58.5% with hold recommendations and 12.3% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's.

Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice.

Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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