Markets & Finance

S&P: Rate Cut Boosts Techs


The research outfit also upgraded its recommendations on the utilities and materials sectors, but lowered its view on health care

From Standard & Poor's Equity ResearchThe Federal Reserve cut both the Fed funds and Discount rates by 50 basis points each, or 1/2 of 1%, on Sept. 18 in what we expect will be a rate reduction cycle that will at least take the Fed funds rate to 4.50% by the end of January 2008. Because of the Fed's anticipated attempt to keep the U.S. economy out of recession, S&P's Equity Strategy Group believes selected cyclical sectors will see improved relative performance in the coming quarters.

As a result, we raised our recommended weighting for Information Technology to overweight from marketweight, and upgraded Materials and Utilities to marketweight from underweight. In turn, we lowered our weighting for Health Care to marketweight from overweight.

Information Technology

We upgraded the S&P 500 Information Technology sector to overweight from marketweight. With U.S. economic growth slowing, we believe this sector's 56% international revenue exposure positions it to outperform as S&P expects overseas economic momentum to remain robust, especially in emerging markets. In addition, most large cap IT companies are more enterprise than consumer focused, further insulating them from ongoing housing market weakness, which could potentially slow U.S. consumer spending. Lastly, after several years of underperformance, we believe the sector is attractive on a p-e to growth (PEG) basis. Despite S&P equity analyst projections for 24% 2008 EPS growth, the sector trades at only 18.8 times 2008 estimated EPS, equating to a forward PEG ratio of only 0.8.

Health Care

We downgraded the S&P 500 Health Care sector to marketweight from overweight. Following market-beating earnings growth projections by S&P analysts for 2007, we see earnings rising in line with the overall market in 2008. The sector trades at a 14% premium to the S&P 500, based on 2008 estimates, which is in line with its historical valuations. We think large-cap health care names are entering into an environment of cost-reductions rather than organic revenue growth, in order to sustain operating margins. As a result, our buy recommendations are concentrated in smaller-cap companies. Also, investors are beginning to question how economically resistant health care companies are, particularly in light of rising cost pressures from Medicare. Finally, these issues may be pressured by the push by either political party in the upcoming election year for some sort of universal health care coverage.

Materials

We upgraded the S&P 500 Materials sector to marketweight from underweight. Despite slowing U.S. economic growth, we expect robust expansions in China, India, Russia and other emerging markets to keep commodity prices elevated, helping the sector's profit outlook. S&P equity analysts project a significant acceleration in S&P 500 Materials sector EPS growth to 14% in 2008 from only 4% this year. In addition, the sector's valuation is low at only 13.8 times 2008 estimated EPS, equating to an attractive 2008 estimated PEG ratio of 1. Lastly, having recently worked off an overbought condition, the sector's technical outlook is attractive, in our view.

Utilities

We also upgraded the S&P 500 Utilities sector to marketweight from underweight. As a result of the recent market pullback, utility valuations have come down, creating buying opportunities, in our opinion. The group has been looked at as a proxy for Treasuries and focused on at times for dividend stability. However, we see limited impact from the economic downturn on the sector and believe demand is not dependent upon employment or consumer spending patterns. While utilities are allowed to pass on increases of higher fuel costs to customers, we believe there are some potential negative effects. Even though usage per customer is likely to stagnate in response to continued high power and gas prices, we expect customer growth to be a partial offset. Operating earnings for the S&P 500 Utilities Index are projected to rise 14% in 2008, higher than our 12% estimate for the S&P 500. Also, a higher sector p-e ratio (15 times, vs. 14 times for the "500") is partially offset by what we see as an attractive dividend yield.

Stovall is chief investment strategist for Standard Poor's Equity Research Services.

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