The Next Leaders and Laggards

11/04/2008 11:00 am EST

Focus: MARKETS

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, Standard & Poor’s equity strategist, tells which sectors he thinks will outpace the market and which will trail in the months ahead. 

While the Standard & Poor’s 500 index’s recent valuation of only 11.8x 2008 estimated earnings may appear cheap by historical standards, the growing likelihood of continued negative profit revisions means current valuations are likely higher than they appear.

In addition, we think widespread global de-leveraging by hedge funds and others has exacerbated fundamental-driven selling. They have been scrambling to meet redemption requests and stricter margin requirements imposed by skittish prime brokers.

The US consumer (whose spending accounts for roughly 70% of economic activity) is under significant pressure as a result of weakening home prices, which we believe will drop further due to a large inventory overhang.

[And] while commodity prices have declined, they remain well above [last year’s] levels, further crimping household balance sheets. Lastly, international economic growth, which previously helped boost both US exports and S&P 500 sales, has weakened dramatically.

While equity prices should undoubtedly lead an upturn in the fundamentals, we believe the global economic and earnings outlook needs to at least show tentative signs of stabilization before any lasting rally will ensue.

In light of this unprecedented global macroeconomic uncertainty, we continue to favor a defensive sector allocation.

We recommend overweighting the health care, consumer staples, and energy sectors, where we believe negative earnings revisions are least likely.

S&P analysts have a positive fundamental outlook on the biotech industry based on an enhanced outlook for sales and earnings over the next 12 months. In addition, we have a positive fundamental outlook for the life sciences tools & services industry, based on our continued favorable view of the contract research organization group and stable growth for life science consumables.

S&P analysts’ fundamental outlook for [consumer staples] is neutral. With commodity prices still historically elevated, credit turmoil showing no signs of abating, housing prices continuing to weaken, and the job market remaining sluggish, we believe investors may gravitate towards defensive, low-volatility sectors, such as consumer staples, with increased revenue and earnings opportunities.

[We also have] a positive fundamental outlook for the energy sector. We see West Texas Intermediate crude oil prices remaining elevated in 2008, averaging $110 a barrel for the full calendar year and $101 a barrel in 2009. Our fundamental outlook for the integrated oil & gas industry, which represents over half the sector’s market capitalization, is positive.

Conversely, we continue to recommend underweighting areas with limited earnings visibility like consumer discretionary, industrials, and utilities.

S&P Economics forecasts consumer spending will decline 0.2% in 2009, following a 0.6% expected increase in 2008. S&P equity analysts have a neutral fundamental outlook on the retailing industry, as the impact of the housing market situation and relatively higher gas prices will likely be offset by several interest-rate reductions.

We believe [industrials are] vulnerable to P/E contraction, as investors increasingly question future earnings growth outlook. In addition, we believe accelerating global credit market turmoil has investors increasingly worried that emerging market gross domestic product growth will continue to decelerate as well.

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