With the "wall of worry" for U.S. stocks appearing to grow higher by the day, Standard & Poor's has made a number of changes in its sector- and asset-allocation recommendations. On Oct. 19, its Investment Policy Committee -- a group of senior managers that oversees all investment-related activity done in S&P's name -- lowered its yearend targets for the S&P 500 index to 1,220, from 1,270, for 2005 and to 1,290, from 1,335, for 2006.
WEIGHTING CHANGES. Why the lowered outlook? The committee points to lower visibility on corporate earnings growth, owing to increasing inflation concerns and a cloudier outlook for consumer spending.
How should investors respond to this less friendly environment for U.S. stocks? The IPC adjusted its recommended asset allocation to 45% U.S. equities (from 50%) and 20% foreign equities (from 15%). The greater emphasis on non-U.S. stocks comes as S&P sees some favorable signs for international equities: Strong GDP and EPS growth (especially in emerging markets), low inflation, a weak dollar, corporate restructuring and M&A momentum, a secular bull market in commodities, and market-friendly political reforms in Japan, Europe, and other countries.
Amid its expectation of a shift in investor focus towards higher quality, more defensive sectors, S&P made substantial changes to recommended sector weightings as well:
10/19/05 Rec. Chg.
LOOKING FOR STABILITY. S&P cites a number of reasons for the defensive shift. First up: Decelerating corporate earnings, which may be exacerbated by a more aggressive rate-tightening program by the Federal Reserve to arrest inflationary pressures. Also, the outlook for consumer spending has become more uncertain in response to expected higher heating costs and tapped-out home-equity lines of credit. Finally, S&P thinks it's unclear how investors will respond to the effect of options-expensing requirements on corporate earnings.
S&P believes investors will gravitate toward companies with proven track records of consistent earnings and dividend growth, as characterized by high S&P
Quality rankings, which measure stability and growth in earnings and dividends over the most recent 10-year period.
The S&P Consumer-Staples and Health-Care sectors are expected to benefit from investor willingness to put a premium on predictable growth in earnings, sales, and return on invested capital (ROIC). Conversely, S&P believes economic uncertainty in the face of rising interest rates and a slowing housing market will prevent outperformance by the more cyclical, economically sensitive sectors, such as Information Technology and Consumer Discretionary.
What was behind the upgrades -- and downgrades -- of each group? Here's a sector-by-sector look:
Health Care: S&P upgraded its recommendation on strong 2006 relative EPS projections, coupled with a high ROIC and S&P Quality Ranking for the sector. S&P's
technical opinion on the sector is positive.
S&P's 5 STARS (strong buy) top picks in the sector are Charles River Labs (CRL
; recent price; $42.32), Genentech (DNA
; $85), Genzyme (GENZ
; $71.20), Gilead Sciences (GILD
; $46.01), Invitrogen (IVGN
; $71.96), Renovis (RNVS
; $13.51), Hologic (HOLX
; $52.99), Mentor (MNT
; $44.54), St. Jude Medical (STJ
; $48.80), Community Health Systems (CYH
; $37.15), Covance (CVD
; $52.10), Dentsply (XRAY
; $52.54), Aetna (AET
; $86.79), UnitedHealth (UNH
; $58.20), WellPoint (WLP
; $76.37), AstraZeneca (AZN
; $46.97), Endo Pharmaceuticals (ENDP
; $26.38), and Teva Pharmaceuticals (TEVA
Consumer Staples: This sector was also upgraded, since it's considered a defensive safe haven offering superior returns on invested capital. Of the companies in the Consumer Staples group, 80% had above-average S&P Quality rankings. S&P's technical opinion on the sector is neutral.
Consumer Staples stocks with a 5 STARS ranking are: Constellation Brands (STZ
; $22.62), CVS (CVS
; $26.01), Colgate-Palmolive (CL
; $52.68), Procter & Gamble (PG
; $55.67), Wal-Mart Stores (WMT
; $45.99), Wrigley (WWY
; $70.46), and PepsiCo (PEP
Industrials: This group was upgraded to Marketweight from Underweight. The above-market EPS growth forecast is likely offset by relatively high valuations and inflation concerns.
; $21.11), Manitowoc Company (MTW
; $51.80), Stericycle (SRCL
; $55), Robert Half (RHI
; $33.16), Danaher (DHR
; $52.44), Ingersoll-Rand (IR
; $37), Burlington Northern Santa Fe (BNI
; $58.20), WW Grainger (GWW
; $65.56), CNF (CNF
; $50.52), and Landstar (LSTR
; $37.96) are 5-STARS-ranked stocks in the Industrials sector.
On the downside:
Consumer Discretionary: S&P lowered its recommendation on this sector because it believes that its earnings-growth outlook is vulnerable. Inflation concerns and potentially muted consumer spending as a result of higher energy costs may weigh on profits. S&P Chief Investment Strategist Sam Stovall thinks consumers may cut back further on discretionary spending due to high heating costs.
Information Technology: This group was also cut based on concerns about earnings and consumer spending. S&P Equity Strategist Alexander Young cites an uncertain investor reaction to the effect of option-expensing requirements on company profits in this group. Another negative sign: 3-STARS-ranked (hold) semiconductor company Intel (INTC
; $23.69), a major tech bellwether, guided estimates for the fourth quarter below Wall Street expectations as a result of inventory build and supply constraints in its chipset segment.
Wang is a reporter for S&P Global Editorial Operations