A Bull Slows Down His Charge


Has the market's best-known bull turned defensive?

Joseph Battipaglia, executive vice-president and chief investment officer of Ryan Beck & Co., swears that his optimism over 20 years has survived more than the recent crop of bad news -- high oil prices, hurricanes, and disturbingly down days for stocks. But his advice now includes the thought that "investors need to be defensive."

His concern extends beyond energy and the destructive weather to prospects for inflation, higher-than-expected interest rates, and a dip in consumer confidence and, thus, spending. So his firm has cut back the equity share of a portfolio to 25% for conservative investors and to 70% for risk-tolerant growth investors. Plus, he recommends an increased dose of gold, to 15% for the conservatives, and says it should be in the form of an exchange-traded fund. Specifically, he mentions the iShares COMEX Gold Trust (IAU).

In the current investment climate, Battipaglia suggests overweighting three stock sectors -- health care, technology, and industrials. Among the names he mentions in health care are AstraZeneca (AZN) and Johnson & Johnson (JNJ). In technology, he cites Microsoft (MSFT), Cisco (CSCO), Motorola (MOT), and Palm (PALM), and in industrials, Parker Hannifin (PH).

These were a few of the points Battipaglia made in an investing chat presented Oct. 6 by BusinessWeek Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from the chat follow:

Joe, you're widely known as a bull. Has your optimism survived hurricanes, oil prices, and the last few down days on the market?

Well, I can assure you it has survived more than that over an extended period of time. In fact, having this bullish outlook over the last 20 years has served our investors very well. But, taking into account these risks recently, including the inflation activity and higher-than-expected interest rate hikes, investors need to be more defensive.

In response, we've cut back our equity allocation from 50% to 25% for our conservative investors, and for our risk-tolerant growth investors, we've cut back from 85% to 70%. It may come as a surprise to some people, but we've increased our gold allocation for each of these types of investors -- for a balanced investor, from 5% to 10%, and for conservative, from 8% to 15%.

Why gold and not other traditional safe havens, such as Treasuries or cash?

We also increased our allocation to Treasuries (only short-term) -- for growth investors, 8% to 12%, balanced, 16% to 24%, and conservative, 26% to 37%. Intermediate-term corporate-bond exposure has also been increased. We find that longer-term bonds are unattractive in the rate environment that we see, so we're concentrating on shorter maturities. We view the short-term Treasury position as being our cash position.

On gold, are you talking the metal itself or stocks?

We are using ETFs [exchange-traded funds] -- iShares COMEX Gold Trust (IAU), in particular, which lets us get the best of both worlds, both the metal and market liquidity. I might add that owning gold coins is so 1970s.

What are you most worried about?

We look at the stock market as being driven by a set of fundamental economic and business inputs. The biggest concerns we have now are that consumer confidence, which has deteriorated greatly, will feed off higher energy costs, the slowdown in real estate pricing, and the aftermath of the Gulf Coast destruction, and translate into weaker consumer spending for the fourth quarter and the first quarter of 2006.

At the same time that this is happening, the Federal Reserve will go beyond what we believe is necessary in terms of interest rate hikes well into the new year.

The critical question will be whether or not the inflationary tendencies that will show up in the next two months are of a passing variety or are structural in nature.

If they're passing in nature, then these rate hikes can come to an end. If they're structural, then the new Fed chairman, starting Feb. 1, will have his hands full trying to contain inflation while not killing the economy. Both of these issues are significant challenges for the stock market in the months ahead.

What sectors and stocks do you see as good defense mechanisms for investors, granted the stock allocation in portfolios may be smaller?

We would recommend an overweighted position in health care, technology, and industrials. Underweight consumer durables and nondurables, financials, and energy.

Retailers reported sales today, and the holiday season is coming. Are you avoiding retailers altogether, given your worries about the consumer?

No. Given how large the consumer category is in the economy, approximately 70%, while we may underweight the sector, certain companies in the subgroupings can do quite well.

Luxuries, for example, can still show a very strong profile. A few our firm likes: Guess? (GES) and Christopher & Banks (CBK) both reported good numbers, and the stocks have responded.

Do you have any names for us in your "overweight" areas -- health care, tech, and industrials?

In the health-care arena, AstraZeneca (AZN) and Johnson & Johnson (JNJ). In technology, Microsoft (MSFT), Cisco (CSCO), Motorola (MOT), Palm (PALM). In the industrials, Parker Hannifin (PH).

Let me also mention a few stocks in the underweighted consumer area. Sony (SNE) and Nike (NKE) both show up as attractive to us in our money-management program, and we own all of the above-named stocks except JNJ.

Are you looking outside the U.S. for stocks at all? Some managers seem to like the diversification potential overseas.

We agree with that conclusion, and the way we're getting at it is to once again use exchange-traded funds to get us positioned internationally. Our foreign-equity exposure for growth investors is 13%. For a balanced investor, it's 9%, and for a conservative investor, 5%.

Two-thirds of each of those positions is in emerging markets, using iShares MSCI Emerging Markets Index Fund (EEM). The reason we have such a strong position outside the United States is the economies outside demonstrating better run rates, not to mention the sloping dollar that works in these nations' favor. This kind of exposure is warranted.

Do you have any predictions -- or concerns -- on who might succeed Alan Greenspan at the Fed?

Like just about everyone else, I would like to see Alan Greenspan's replacement be an independent free-market economist who has some financial-market experience and appreciates the importance of market prices in guiding policy decisions. A couple of names that have come up that could work include Manuel Johnson, Robert McTeer, Glenn Hubbard, and Benjamin Bernanke, to name a few.

I distinctly remember back in '86 going into '87 that the markets were concerned that nobody could fill Paul Volcker's shoes, when out of nowhere comes dark-horse candidate Alan Greenspan, who turns out to be arguably one of the world's best central bankers. So I believe a suitable replacement can certainly be found.

Do you think the market is pricing in earnings disappointments for the third quarter? I hear that the bull argument is earnings will recover in the fourth quarter from rebuilding after Katrina.

I actually think that third-quarter earnings will come in better than expected, based upon preliminary work looking at tax receipts for the third quarter. The problem isn't so much whether this quarter meets or beats expectations, but what are we in store for the next quarter and beyond? As new challenges confront the marketplace, we may see erosion of margins and the ultimate deceleration of earnings that has been widely anticipated.

Couple that with rising interest rates and the width of inflation (structural or otherwise), and you can see how price-earnings multiples would contract in the face of those developments.

It's interesting that the first of the Dow components, Alcoa (AA), will report next week, and it will likely be a lousy result. Notice the stock hit a low today. I'm sure that those who disappoint will suffer a harsh response -- notice Lexmark (LXK) earlier this week. Those who meet the number will meet with some price relief but will no doubt be greeted with some skepticism as to the sustainability of their performance.

With a defensive stock strategy, are value stocks a better play than growth stocks?

Our work has shown that you can pretty much pick between them. Value has come a long way in outperforming relative to growth, so the p-e on growth has narrowed while expanding in value. Exxon Mobil (XOM) used to be classified as value and is now growth.

You should start with the financials and not a moniker like growth or value. Investors need a wide net of coverage in picking stocks.

What financial stocks might you like?

We would view some of the broadly based money-center banks like Citigroup (C) and JPMorgan Chase (JPM) as attractive opportunities to play the global marketplace for banking and the rebirth of capital-market activity. We like Goldman Sachs (GS) and have also been big fans of smaller banks -- banks going through conversions like Hudson City Bancorp (HCBK).

But as you can imagine, the performance of your rank-and-file banks as the yield curve flattened and short-term money costs rose has been mediocre at best after four strong years of outperformance. Once again, you need to pick your stocks carefully, vs. buying a basket of small and regional banks and expecting substantial outperformance.

There are security threats being reported in New York City subways at the moment. And this week we're hearing about avian-flu worries. Should investors pay much attention to these concerns?

The answer is yes, but we've had numerous incidences where terror alerts are raised and then lowered. We had the SARS "crisis," which didn't amount to much. So we have to look at these various exogenous variables and come to a sense of order of magnitude with each.

Remember, the subway bombings and bus bombings in London did not upend the global economy or world markets, the SARS epidemic disappeared almost as quickly as it presented itself, and if I might say, this avian-flu news may benefit drug companies -- it may well be a crisis that never appears.

I hope this is the case. I'm hopeful because of the aftermath of Katrina and Rita -- no terrorist attempts were made, which speaks to the weakness of al Qaeda in the U.S. So these factors shouldn't be a tipping point for the economy and the markets.

BusinessWeek Online investing chats are presented every Tuesday and Thursday from 4:30 p.m. to 5:30 p.m. ET. For more information go to www.businessweek.com/investing


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