It’s Still Time to Stay Defensive

12/09/2008 11:00 am EST

Focus: MARKETS

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, equity strategist for Standard & Poor’s, says there’s too much uncertainty about the macroeconomic outlook to plunge into the markets just yet.

While the Standard & Poor’s 500 index’s recent rally off its November 20th closing low of 752.44 represents a welcome reprieve after months of relentless selling, we believe a retest of the lows is likely.

Although recent volatility has at least discounted significant earnings erosion, as well as a looming global recession, the consensus also expects the economic and profit picture to improve in the second half of 2009. Should the current worldwide downturn be longer and deeper than expected, we think equities will be vulnerable to further selling when markets discount a bleaker than expected outlook.

Given the unprecedented scope of global deleveraging, hedging against a “longer and deeper” scenario appears prudent. In addition, while the S&P 500’s recent valuation of only 12.5x 2008 estimated earnings may appear cheap by historical standards, the possibility of continued negative profit revisions means current valuations are likely higher than they appear.

The US consumer, whose spending accounts for roughly 70% of economic activity, is under significant pressure—the result of weakening home prices, which we believe have further to fall because of a large inventory glut.

In addition, international economic growth, whose past strength helped boost both US exports and S&P 500 sales, has weakened dramatically, with Europe, the United Kingdom, Canada, Japan, Australia, and New Zealand all in or flirting with recession.

Overseas economic weakness has boosted the US dollar, further eroding the benefit of the S&P 500’s approximately 45% foreign revenue exposure.

While equity prices will 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. With the credit crisis 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.

We recommend overweighting consumer staples, reflecting our view of above-average earnings growth expectations and profit predictability.

We [also] recommend overweighting energy, as we think low valuations will lead to a resumption of broader market outperformance. While West Texas Intermediate oil prices have dropped more than 65% since July, recent oil prices around $50 per barrel are still roughly in line with the past five-year average.

We believe investors [also] should overweight health care. Equity volatility will likely remain elevated, [so] we think investors will reward the sector’s defensive qualities, allowing for better relative performance. S&P analysts have a positive fundamental outlook on the biotech industry based on an improved outlook for sales and earnings over the next 12 months.

[Finally,] we recommend overweighting the telecommunications sector, due to our positive fundamental outlook, its above-average yield, and improving technical readings.

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