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Monday Morning Musings: More Defense
05:35pm EST 5-Mar-04 Smith Barney Citigroup Equity Strategy
Monday Morning Musings: More Defense
March 5, 2004 SUMMARY * We are continuing to become increasingly Tobias M. Levkovich defensive on the market. * Our year end 2004 S&P 500 target remains 1,025, roughly 11% below current levels. Lori Calvasina * We have lowered Banks to underweight from market weight (which takes our overall stance on Financials to underweight) and are lifting Lorraine Schmitt Energy to overweight from market weight. * In conjunction, we are adding both MDU and Cooper Cameron to the Smith Barney Recommended List, while removing Jabil Circuit and Keyspan. OPINION
We have been advising investors to take on a more defensive equity market posture over the past five-to-six weeks, having taken the Information Technology sector to an underweight on January 30 and having upped both the Consumer Staples and Health Care sectors from underweight stances. Moreover, we continue to believe that the equity market (as measured by the S&P 500 index) may end the year at 1,025, down 11% from current levels. However, in our view there is a fairly decent probability that we are down more than that by the summer, with some recovery closer to year-end during the seasonally strong fourth quarter. Our main rationale for a weaker market rests on the concern that equity market bullishness is excessive (in our opinion), analysts' earnings estimate revisions have now established new higher hurdles that may limit upside EPS surprises and provide fodder for disappointments (such as the one delivered by Intel) in what we deem an earnings momentum driven market, and increasing capacity in the semiconductor arena that should generate downside pressure on technology stocks, if history is any guide.
Layered on top of our three aforementioned major worries is the likelihood that 10-year Treasury yields will climb by year-end (due to sustained economic growth, despite the recent jobs numbers), compressing P/E multiples, and that high oil prices may represent a challenge to consumer spending this summer, with some forecasters beginning to worry about $3/gallon gasoline in the U.S. As a reminder, every penny per gallon change equates to roughly $1 billion of annualized spending that arguably could be better spent on other items. Thus, stubbornly-high energy prices may represent a new growing risk, although we also must acknowledge that the calendar is now entering the seasonally slow, so- called "shoulder" months between winter heating energy requirements and summer driving needs, which should lead to weaker prices. However, inventories remain quite tight and Venezuela (one of the four largest sources of U.S. oil imports) is being rocked once again by political unrest.
Sector/Industry Group Weighting Changes
Accordingly, in this context, we are making two additional changes to our industry group and sector allocations, by lowering Banks to underweight from market weight and lifting Energy to overweight from market weight. Moreover, by virtue of this move in the Banks, we are actually taking the Financials sector down to a slight underweight from the prior slight overweight position, with only the Insurance industry group remaining in the overweight column due to continued pricing power. Note that Smith Barney bank analyst Ruchi Madan believes that investors should underweight the banks as well.
Our Banks downgrade logic recognizes that the net interest margin earnings story is well-disseminated and the mortgage refinancing activity opportunity seems pretty much behind us at this juncture. But the potential for rising rates over time and a more challenging valuation environment (see Figure 1) compels us to pull back on the group. Note that our proprietary banks valuation composite (which is based on the best four correlative valuation metrics to future 12- months group stock price performance) has spiked of late, suggesting that the industry looks overvalued. Nonetheless, takeover opportunities do exist in the banking arena and select names could offer investors upside potential. Indeed, Ruchi Madan listed a number of potential takeout candidates in her February 20 Bank Weekly, including US Bancorp and Sovereign.
Figure 1
Note: Valuation composite based on dividend yield, price/book, FY1 P/E, price/sales
Source: Smith Barney US Equity Strategy Nota: immagini disponibili solo nel report in formato PDF.
The key catalyst for the Banks to underperform is likely to be rising interest rates, as one can see from Figure 2 that bond yields and bank industry group relative performance are inversely related. Given the recent jobs numbers, yields have slipped again, supporting Financials stock prices. Nonetheless, further weakness in bond yields could crimp margins. Thus, the flexibility available to banks regarding valuations or earnings is becoming more complicated.
Figure 2
Source: Factset and Economy.com Nota: immagini disponibili solo nel report in formato PDF.
On the Energy side, we would stress that our upgrade to overweight is a defensive move and should not be taken as a bullish statement for energy stocks. As can be seen below, the Energy sector typically outperforms when the broad market sags (see Figure 3). As such, given our belief that the S&P 500 could slide as much as 15% by this summer, the Energy sector looks appealing to us.
Figure 3
Source: Factset Nota: immagini disponibili solo nel report in formato PDF.
Bear in mind that our top-down Energy valuation composite (see Figure 4) does suggest that the stock prices are appealing. It is possible that oil stocks will slip in the next few months; Smith Barney's integrated oil analyst, Doug Leggate, is less enthused about the oil names as a result of likely seasonal oil price weakness. We do not disagree, but simply think that they may outperform the broader averages. On the other hand, exploration & production names could do well with high natural gas prices.
Figure 4
Note: Valuation composite based on EV/EBITDA, dividend yield, price/sales, price/gross cash flow
Source: Smith Barney US Equity Strategy Nota: immagini disponibili solo nel report in formato PDF.
Figure 5 outlines our new industry group and sector weights, showing us to be overweight Energy, Consumer Staples, Consumer Discretionary, and Industrials, and underweight Financials (slightly), Information Technology and Utilities. Our positive Industrials posture reflects better industrial activity and related incremental margin opportunity for Capital Goods producers, but we are wary of the calendar capital goods companies that often underperform from May through October. Thus, investors may need to trade out of industrial names in a couple of months.
Recommended List Changes
In conjunction with our upgrade, we are adding both MDU Resources (swapping it for current list constituent, Keyspan) and Cooper Cameron to the Smith Barney Recommended List, while removing Jabil Circuit. Our removal of Jabil Circuit reflects our caution on IT, while our swap of MDU for KSE and our addition of Cooper Cameron reflect our defensive move into energy. Our new utility constituent, MDU, is a diversified natural resources company with operations in natural gas transmission, exploration and production, utility services, independent power as well as construction materials and mining. The stock appears attractively valued, trading at 14.4x 2003 earnings and 13.7x 2004 earnings estimates. Cooper Cameron represents another vehicle to participate in a likely pickup in exploration & production activity. Moreover, we continue to recommend Halliburton.
As a reminder, in our February 20 Monday Morning Musings we highlighted our view that easy comps, tax benefits, the lack of war, the absence of SARS, and improved hiring prospects should help cyclical consumer stocks over the next few months, which generated our addition of Staples to the Recommended List.
Figure 5 -- Recommended Sector and Industry Group Weightings
Source: Smith Barney Equity Strategy and Factset Nota: immagini disponibili solo nel report in formato PDF.
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