Stocks: A 5% Jump by Yearend?


Despite threats to the economy from energy costs and hurricanes, the stock market is poised to rise 5% from now to yearend, as measured by the Standard & Poor's 500-stock index. That prediction comes from S&P's investment policy committee, as reported by Kenneth A. Shea, managing director of S&P Equity Research Services. Such a gain would take the index to 1270.

The market sectors favored by S&P are information technology and consumer discretionary. In info tech, S&P lists as strong buys Automatic Data Processing (ADP) and Fiserv (FISV), says Shea. It also likes home entertainment software, especially for video games and online and wireless gaming, and in that group names as a buy Activision (ATVI). In the consumer discretionary sector, S&P focuses on apparel, accessories, and luxury goods makers -- among them Coach (COH), which is a strong buy.

Energy stocks have been downgraded to market weight, largely because of their two-year leadership in the market. But Shea reports that S&P still sees opportunity there and rates as strong buys such stocks as Nabors Industries (NBR), Baker Hughes (BHI), Smith International (SII), ConocoPhillips (COP), and Exxon Mobil (XOM).

These were a few highlights of remarks by Shea in an investing chat presented on Oct. 4 by BusinessWeek Online and Standard & Poor's, in response to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat.

(Kenneth Shea is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.)

Ken, the market has been repeating its behavior pattern of recent weeks and months. What's the latest diagnosis from S&P?

The S&P investment policy committee remains constructive on the U.S. equity market and pegs a yearend S&P 500 target of 1270, which translates to an approximate 5% gain through the rest of the year. Longer-term, the investment policy committee believes that the market can continue to make steady albeit unspectacular gains, driven chiefly by low-teen operating earnings growth and an increased embrace of equities by investors following what we believe will be the current Fed tightening cycle and an increased appetite by corporations to put capital spending to work.

Assuming this scenario proves accurate, S&P Equity Research believes that good opportunities exist in the information technology and consumer discretionary sectors, both of which generally benefit from growth in the job market.

Have you made any changes recently to your sector recommendations?

Just prior to the Katrina hurricane tragedy, S&P chief investment strategist Sam Stovall advocated an economically sensitive stance in recommending overweighted postures in consumer discretionary and information technology, while reducing his formerly bullish stance on energy, health care, and utilities to market weight.

Some analysts attributed today's market decline to worry over corporate earnings -- do you share this worry?

No. I would tie today's dip to comments made by Fed Governor [Richard W.] Fisher that said inflation is running at the upper end of the Fed tolerance zone, with no sign of moving lower. These comments seemed to outweigh a considerable drop ($1.57 per bbl.) in crude oil prices. Interest-sensitive sectors, such as homebuilding, were hurt, while relatively defensive areas such as health care were strong.

S&P's view is that the Fed remains ahead of the inflation curve and that both actual inflation and inflation expectations will remain essentially in check. S&P chief economist David Wyss projects a core consumer price index rise of approximately 2.2% in '05 and 2.4% next year. This anticipated muted level of core inflation is expected to keep the 10-year Treasury note yield below 5%, a level that S&P believes will support positive equity market action ahead.

What stocks does S&P especially like in the favored sectors of info tech and consumer discretionary?

Standard & Poor's recommends investors modestly overweight their investment portfolios toward information technology stocks, and the S&P equity analysts are particularly positive on the data processing and home entertainment software industries.

Therefore, S&P favors companies such as Automatic Data Processing, which sports a lofty A+ S&P quality rating, and Fiserv. The latter company, which sports an S&P quality rating of B+, is a provider of account processing and integrated information management systems for financial institutions. Both Fiserv and ADP are S&P 5-STARS [strong buy in STARS -- S&P's Stock Appreciation Ranking System].

In the home entertainment software area, S&P sees the video-game software industry benefiting from the mid-to-late stages of the latest console hardware cycle, which began with the late 2000 release of Sony's Playstation 2, the first of three next-generation platforms released in this cycle. S&P sees some positive catalysts for video-game software providers in 2005 and 2006.

These catalysts include the continued buildout of online and wireless gaming, the recent launch of Sony's Playstation portable, and the anticipation of next-generation consoles. S&P's favorite stock in this industry is Activision, which carries a 4-STAR (buy) recommendation.

You updated us on info tech names, Ken -- now what about specifics in consumer discretionary?

As I mentioned before, Standard & Poor's recommends investors overweight their exposure to that sector. From a fundamental standpoint, S&P sees consumer spending rising at an approximate 3.5% rate this year and a touch below 3% next year, despite likely higher interest rates and any near-term disruption caused by the hurricanes and higher gasoline prices.

Although the housing market is likely to cool from its recent pace, we still believe that favorable demographics and positive affordability levels nationally will continue to give housing demand a lift in the intermediate term. This in turn should prop up consumer confidence and demand for consumable goods.

In particular, Standard & Poor's favors apparel, accessories, and luxury goods makers, including Coach, which is ranked 5-STAR, Liz Claiborne (LIZ) (4-STAR), and Polo Ralph Lauren (RL), also ranked 4-STAR.

Do you like any housing stocks?

As just mentioned, Standard & Poor's believes the homebuilding group should benefit from favorable demographic trends, continued job growth, and accommodative mortgage rates in the intermediate term.That said, the stocks have performed weakly recently on investor concerns over talk of a housing bubble burst and the Fed's determination to push interest rates higher.

Our view in this environment is for investors to take a long-term approach on these stocks, many of which trade at significant discounts to the overall market. For example, Lennar (LEN) (3-STAR or hold by S&P), which carries a high quality ranking of A-, is a homebuilder that trades at only seven times its expected earnings per share for fiscal year 2005.

Our view is that investor fears may very well be overblown for Lennar and many other high-quality publicly traded homebuilders that include MDC Holdings (MDC) (5-STAR, A+ S&P quality rank), DR Horton (DHI) (4-STAR, A+ S&P quality rank), Hovnanian Enterprises (HOV) (4-STAR, B+ quality ranking), and Toll Brothers (TOL) (3-STAR, B+ quality ranking).

You're no longer so bullish on energy. What does S&P think the current price and supply situation will do to energy companies and their stocks? Any you still like?

Although Sam Stovall has a market-weight recommendation on energy, owing largely to its unabated two-year leadership in the market, the S&P equity analysts remain positive on the fundamental outlook for the sector, reflecting expectations for strong demand from healthy global economic growth, continued growth in refining margins, oil prices that are likely to remain above $55 through 2006, and rising capacity utilization for drillers.

S&P analysts' favorite stock selections include oil and gas drillers such as Nabors Industries (5-STAR, S&P quality ranking of B) and Noble Energy (NE) (4-STAR, B- quality ranking). Oil and gas equipment services companies we like include Baker Hughes (5-STAR, quality ranking B) and Smith International (5-STAR, quality ranking B). Integrated oil and gas companies ConocoPhillips (5-STAR, quality ranking B) and Exxon Mobil (5-STAR, A- quality ranking) are also in good favor.

Third-quarter earnings season is approaching -- what's your outlook? Do you expect to see more warnings this season due to higher oil prices and the hurricanes?

As the third-quarter season approaches, I believe it may be one of the most closely watched quarters in a long time, owing to a few factors. First, it is widely anticipated that the third-quarter earnings season would represent the 14th consecutive double-digit gain in operating earnings for the S&P 500.

Second, the extent of the damage caused by the hurricanes is wide-ranging and has not been well identified yet by Corporate America. Third, companies typically begin to give look-ahead guidance to the following year with their third-quarter results.

S&P equity analysts expect a robust 16% rise in operating earnings in the third quarter, led by very strong gains in the energy sector and, to a lesser extent, in the industrials and information technology sectors. Given the fairly high expectations, however, it is plausible to believe that earnings disappointments viewed as unrelated to the Katrina and Rita hurricanes could very well be met with strong downside pressure.

In addition, the current consensus thinking is that 2006 will be another year of strong, albeit slower, earnings growth. If third-quarter guidance leads investors to reduce this expectation, this could also dampen near-term market activity.

Ken, could you explain the S&P quality rankings? What are the criteria? Is this something investors should take into account along with your STARS rankings?

Yes, absolutely. S&P earnings and dividend rankings, a.k.a. quality rankings, convey the relative growth and stability of earnings and dividends generated by a company over a trailing 10-year period. The scoring system, which was developed by Standard & Poor's more than 50 years ago, has been a powerful tool in assisting investors in identifying companies with superior risk-adjusted investment return prospects.

It continues to be used closely by S&P equity analysts, as well as many of the most astute investors on Wall Street. Standard & Poor's assigns quality rankings on more than 3,000 U.S. companies, and they are a fixture on the ubiquitous S&P stock reports and S&P MarketScope service.

Finally, Ken, does S&P have a current edition of its Top 10 portfolio of strong buy stocks?

Yes, S&P's popular Top 10 portfolio can be found on S&P MarketScope, as well as the BusinessWeek Online investing page (businessweek.com/investing), and currently consists of the following stocks: Oneok (OKE), PepsiCo (PEP), Bank of America (BAC), MDC Holdings, Smith International, Covance (CVD), St. Jude Medical (STJ), Burlington Northern Santa Fe (BNI), Ingersoll-Rand (IR), and Guitar Center (GTRC).


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