Recession Risk Rises

01/28/2008 12:00 am EST


Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, Standard & Poor’s chief investment strategist, says a recession is more likely now, and he urges investors to get more defensive in their portfolios.

Standard & Poor’s Economics raised its recession risk forecast to 50% from 40% on January 4th. As a result, S&P’s Investment Policy Committee lowered its 2008 yearend target on the S&P 500 index to 1,560 from 1,650, and S&P Equity Strategy revised six of its sector recommendations.

“The economy is expected to be very slow in the first half of 2008,” says chief economist David Wyss. “Whether it will count as a recession will be a technical decision, but we think the odds that an actual recession will result have risen to even.”

While the housing market has garnered the lion’s share of the headlines, it’s not enough to cause a recession, he says. Residential construction subtracted 1.0 percentage point from real GDP growth over the past four quarters.

Wyss notes that foreign trade and capital spending have offset the drag from the housing sector. “We expect this to continue in 2008, as a weaker dollar and still-strong foreign economic growth help exports, while imports continue to slow because of weaker US demand,” Wyss says. “The danger is that the foreign economies may weaken more than expected.”
With these potential scenarios in mind, S&P revised more than half of its sector recommendations.

We upgraded consumer staples to overweight from market weight. With investor risk aversion rising as economic growth slows, we believe the sector’s predictable revenues, low volatility, above-average international exposure, and a recent 2.3% dividend yield will allow it to outperform.

We upgraded energy to overweight from market weight. Technically speaking, the S&P 500 Energy index has been in an up trend since the beginning of 2007. We also believe energy stocks represent a geopolitical hedge, as terror is impossible to predict. Lastly, the sector recently traded at only 12.4x 2008 estimated earnings—the second lowest in the S&P 500.

We downgraded information technology to underweight from overweight. Slowing global economic growth is causing investors to be more risk-averse, making a repeat of 2007’s strong outperformance unlikely. The information technology sector’s P/E of 18.1x is the highest in the S&P 500.

We downgraded industrials to underweight from market weight. With the US economic slowdown accelerating, we believe this cyclical sector is vulnerable to P/E contraction, as investors increasingly question its future earnings growth outlook. [And] the sector’s valuations are relatively high, given how late we are in the current economic cycle.

We upgraded health care to overweight from market weight. We recommend investors increase their exposure to traditionally defensive sectors, such as health care, because of the relatively static demand for their products and services. We also think the sector’s predictable revenues, low volatility, and above-average international exposure will allow it to outperform on a relative basis.

We upgraded utilities to overweight from market weight. Utilities [are defensive stocks] since there is always demand for their services. We expect earnings in this sector to increase 12% in 2008. We also believe the recent 2.9% dividend yield should offer further support.

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