ww w.o C O M utl E V I ook S I T .sta U S nda O N rda L I N E ndp ! oor s.c om
The Outlook Intelligence for the Individual Investor
December 19, 2007 Volume 79 Number 48
Looking Ahead The S&P PowerPicks Portfolio 2008 contains stocks that S&P
Election Outlook Tax Implications High-Yield Bonds
equity analysts believe are positioned for superior total
International Predictions Sector Signposts
return during the year ahead. It is diversified among all 10 of the economic sectors that make
up the S&P 500. To see the domestic and global picks, please see the January 9 issue
STOCK MARKET 1970 -2007
IMPORTANT NOTE: The next issue of The Outlook will go to press on December 28 and be dated January 2. No issue will be published next week.
Please see page 3 for required research analyst certification disclosures. For important regulatory information, please go to: www.standardandpoors.com and click on “Regulatory Disclosures.”
of The Outlook. 1000 900 800 700 600 500
Standard & Poors 500 Composite
1000 900 800 700 600 500
1941-1943=10 (Logarithmic Scale)
(Gray areas represent declines of 10% or more)
100 90 80 70 60
Annualized Total Return from 12/31/69 through 11/30/07 is 11.1%.
1970 71 72 73 74 75 76 77 78 79 1980 81 82 83 84 85 86 87 88 89 1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 06
100 90 80 70 60
2 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
Tougher Times Ahead
A weak housing market, a slowdown in consumer spending, and tight credit markets are likely to result in slower economic growth in 2008. Standard & Poor’s Economics expects continued economic expansion in 2008, but at a slower pace, particularly in the first half of the year, as the contraction in the housing sector plays out and turbulence continues in the credit markets. The large inventory of unsold homes is likely to delay any recovery
Beth Ann Bovino Senior Economist
in building activity. We expect starts to hit bottom this year, and they should stay near that level throughout most of 2008. However, prices will continue to drop even after the recovery begins since there are so many homes on the market. We expect the economy to grow at an annual rate of 1.3% in the
SECTOR PERFORMANCE S&P 500 SECTORS
Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities S&P Indexes S&P/Citigroup Growth S&P/Citigroup Value
S&P 500 2006
-9.6 13.8 27.7 -15.6 9.4 12.7 16.8 23.0 6.9 19.7 6.1 9.3 3.0
17.2 11.8 22.2 16.2 5.8 11.0 7.7 15.7 32.1 16.9 13.6 9.4 18.0
S&P MIDCAP 400 YTD 2006
-3.9 19.8 37.6 -10.0 14.2 23.1 11.0 25.4 14.5 6.0 10.1 16.2 4.2
S&P SMALLCAP 600 YTD 2006
1.7 14.0 1.9 13.0 -1.2 11.6 14.0 14.2 47.0 18.1 9.0 5.2 12.6
-18.2 4.2 22.5 -20.6 16.4 13.1 12.0 18.0 -30.6 2.2 1.9 8.3 -3.7
7.6 28.7 17.6 12.1 8.5 17.5 9.2 30.1 34.9 23.2 14.1 10.0 18.0
Price % changes as of November 30, 2007.
MARKET MEASURES INDEX
S&P 500 Composite S&P MidCap 400 S&P SmallCap 600 S&P SuperComposite 1500 Dow Jones Industrials Nasdaq Composite S&P Global 1200 BBB Indus. Bond Yield (10-yr.)
CLOSE % CHG. THURS. YEAR TO 12/13/2007 DATE
% CHG. PAST 52 WKS.
‡OPERATING —EARNINGS— E2007 E2008
INDICATED ANNUAL % DIVIDEND YIELD
1488.41 868.96 398.70 335.82
4.9 8.0 -0.3 5.0
4.3 6.5 -1.1 4.3
88.49 44.68 20.38 19.65
102.31 51.97 24.18 22.76
14.55 16.72 16.49 14.76
28.53 10.97 4.09 6.16
1.92 1.26 1.03 1.83
13517.96 2668.49 1787.52 6.67
8.5 10.5 8.8 0.55 ◊
8.6 8.6 8.9 0.60 ◊
818.68 ... ...
958.64 ... ...
14.10 ... ... ...
306.52 ... ... ...
2.27 ... ... ...
Data through December 13, 2007. E-Estimated. †Based on estimated 2008 earnings. ‡Before special factors. ◊Actual change in yield (not percentage change).
For even more market intelligence, visit www.outlook.standardandpoors.com.
first half of 2008, down 1.5% from an expected 2.8% for the second half of 2007, before rebounding to a 2.5% rate through the second half of 2008. Some economists now believe a recession is likely next year. While we are less bearish, we still put the probability of a recession over the next 12 months at 40%. We think a recession would be more likely if there is a sharperthan-expected drop in the housing sector and an extended and more severe credit correction. U.S. dependence on foreign capital could cause a spike in bond yields, as foreign investors see the dollar sink and credit losses increase, thus complicating the housing contraction. The geopolitical risk coming from the Middle East and a renewed surge in oil prices (which earlier in 2007 hit $98 a barrel) could also end the recovery prematurely. The lower growth assumed for early next year gives less room for policy mistakes or external shocks. However, an accommodative monetary policy, a decline in the price of oil, and solid exports from a lower dollar and global growth should help lower the recession risk. On December 12, the Federal Reserve and four other central banks announced plans to extend loans to banks to encourage borrowing and lending. The slowdown should hit jobs. We expect the unemployment rate to climb to 5.2% in the third quarter of 2008 from the expected 4.7% at year-end 2007. Payroll increases are expected to average about 100,000 per month in 2008, somewhat slower than in the last 12 months, but this is subject to substantial risk.
STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
ECONOMIC GROWTH PROJECTIONS ECONOMIC INDICATOR
Real GDP Consumer Spending Equipment Investment Nonres. Construction Exports Inflation (Core CPI) Yield on 10-Year Note*
2.9 3.1 5.9 8.4 8.4 2.5 4.8
2.2 2.8 1.5 12.3 8.2 2.3 4.6
1.9 1.8 4.3 0.0 10.1 2.1 3.9
*Annualized average. E-Estimated.
GLOBAL VALUATIONS INDEX
S&P 500 Euro 350 MSCI Japan MSCI Pacific ex-Japan MSCI Emerging Markets S&P/Citigroup World ex-US
14.7 12.3 15.7 16.8 13.3 13.1
18.1 15.8 24.0 15.1 12.4 15.8
E-Estimated. Source: Standard & Poor’s, MSCI. Data through December 7, 2007.
S&P 500 VALUATIONS S&P 500 AT 1505 ON 11/30/07
P/E on Trail. 12-mo. EPS Prem./Disc. to Avg. P/E Since '88 Average P/E Since 1988 P/E Ratio on 2007E EPS P/E Ratio on 2008E EPS Average P/E Since 1935
——P/E RATIOS—— OPERATING GAAP
-0.1 19.4 16.9 14.6 NA
-0.2 22.7 19.2 16.5 15.7
E-Estimated. NA-Not available.
S&P OPERATING EARNINGS 120
87.72 88.94 76.44
80 60 40
54.69 46.04 38.85
2000 2001 2002 2003 2004 2005 2006 2007E 2008E
E-Estimated. All of the views expressed in this research report accurately reflect the research analysts’ personal views regarding any and all of the subject securities or issuers. No part of the analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
Employment and personal income trends largely drive consumer spending, which is expected to slow to 1.8% in 2008 from an expected 2.8% in 2007. Consumer spending is also likely to suffer from the effects of the slow housing market and reduced credit availability. However, we think business equipment spending growth will be higher in 2008 than in 2007. Timing issues, given a three-year replacement cycle and strength in 2005 (up 9.6%), also support our forecast for 2008 growth. Aggregate demand from global economic expansion and the softer dollar will also support business investment next year. We expect business equipment spending to rise to 4.3% in 2008 from 1.5% in 2007. S&P predicts the price of oil will decline from the current level above $90 a barrel, but remain elevated by historical standards at around $75 a barrel by the middle of next year on supply concerns and geopolitical risks. As a result, the consumer price index (CPI) is expected to average 2.9% in 2007, but decelerate to a 2.1% rate in 2008, before falling back further to 1.6% in 2009. In terms of monetary policy, we think the Federal Open Market Committee will likely reduce the target Fed funds rate by another 25 basis points to 4.0% at the January meeting, and cut another 50 basis points in the first half of 2008 to reach 3.5% by April. On the earnings front, S&P chief investment strategist Sam Stovall says it appears the S&P 500 will eke out less than a 1.5% improvement in operating profits in 2007. S&P analysts and the consensus previously expected a 10% advance in earnings, following a jump of nearly 15% in 2006. But worries surrounding the near 5% decline in the median U.S. home value and a jump in oil prices combined to slow consumer spending in October. In addition, there were more than $50 billion in writedowns
4- AND 5- STARS VS. MARKET 5-STARS
DOW JONES INDUSTRIALS
AVERAGE COMPOUND ANNUAL GAIN (1/1/87-11/30/07)
Five-STARS stocks, which are those Standard & Poor’s ranks highest for potential year-ahead appreciation (see page 6), have outperformed the major market indices by a wide margin over recent years. The compound annual gain of 16.0% for the 5-STARS group from the start of 1987 to November 30, 2007 was 1.8 times the gain for the S&P 500. Performance results of the 5-STARS stock group have been calculated using standard time-weighted performance formulae. Since results are exclusive of transaction costs and dividend income, the actual results obtained by investors may be different. Because 5STARS recommendations are made with the intent of maximizing gains, the volatility of the group is likely to be above average. There is no assurance that the future performance of any or all 5-STARS stocks will match the past performance, and you should understand that such recommendations do not take into account a subscriber’s personal circumstances, such as tolerance for risk, investment goals, or access to investment capital.
associated with subprime mortgages. It’s easy to understand why the S&P 500 consumer discretionary and financial sectors will each post an estimated 13% decline in operating earnings in 2007. For 2008, the earnings outlook for the S&P 500 looks a lot rosier, possibly as a result of the projected impact of the Fed’s interest rate cuts that began in the third quarter of 2007. S&P analysts expect earnings to improve 15.6% in 2008, led by profit increases of more than 20% for the consumer discretionary, information technology, and telecommunications sectors. They also expect below-average, but positive, growth from consumer staples, energy, and materials. ■
4 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
hile it’s impossible to predict the No. 1 news event of 2008, there’s no doubt the U.S. presidential election will, at the very least, be a contender for the top spot. Will the Democrats retake control of the presidency? Will Republicans maintain their hold? Will a third-party contender be the surprise choice? While Standard & Poor’s Equity Research cannot predict the outcome of the presidential election, our strategists and analysts believe news from all the candidates will certainly move markets in 2008. In general, the S&P 500 index has performed well during presidential election years, rising an average of 8.6% since 1945. The market has posted gains 80% of the time in presidential election years. While past performance ANNUAL is no guarantee of future FORECAST results, S&P’s Investment Policy Committee believes, based on many factors including the Beth Piskora presidential election Managing Editor, U.S. Editorial cycle, the S&P 500 will end 2008 at 1,650. That would represent a 6% increase from our year-end 2007 target of 1,560. S&P Chief Investment Strategist Sam Stovall foresees three major presidential election campaign issues: 1) Iraq/defense spending, 2) health care, and 3) energy.
Electric and ABB Ltd.); and greater efficiency in manufacturing (which could benefit ABB, Emerson, Rockwell Automation, and Roper Industries). In terms of trucks & rails, the Democrats appear more willing to regulate and/or impose more restrictions on the transportation sector. This could make operating trucks and trains more costly. There are two areas where we could see politicians becoming active (not necessarily tied to the presidential election): an increase in the fuel tax and, at the state level, general increases in sales and corporate tax rates. Both rails and trucks are well advanced in implementing fuel surcharge clauses in their contracts, and both industries are generally more than 90% covered now. There has been a lot of noise about the need for rails to invest in their infrastructure in order to support projected traffic increases over the next 20 years. However, a general stand off has occurred, as the rail managements say they will not invest unless the project meets the minimum return on investment capital (ROIC) threshold. Translation: we demand government help via tax credits, otherwise investment will be slow in coming; and government officials (Democrats) appear stuck in the “paygo” loop, where new spending must be offset by reductions elsewhere. A Democratic president may focus more on environmental projects, including emissions control, water infrastructure, and alternative energy, plus transportation-related projects. SAFETEALU (Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users) expires in 2009, so the funding size of a new transportation bill will determine whether more highway, airport, and bridge projects are booked. A Republican president may focus more on the defense budget and homeland security. This could have a big effect on construction & engineering
2008 Election Outlook
Industrials/Defense S&P thinks the 2008 election could be very significant for defense contractors, particularly if there are Democratic majorities in both houses of Congress, as well as a Democratic president. Following such a victory, we would likely become neutral on the defense sector vs. our current positive stance, due to the projected reduction in defense spending. We also think that both parties will
Standard & Poor’s Equity Research believes election news will most likely move markets in 2008. generally support spending on projects related to construction & engineering and industrial machinery, although the two parties might favor different types of projects in these areas. We expect the Democrats to focus more on environmental projects, including emissions control, water infrastructure, and alternative energy. We see the Republicans, on the other hand, being more interested in a larger budget for the Defense Department and homeland security — which, on top of aiding defense companies, would also likely assist construction & engineering companies that serve that area. Of course, any spending related to the maintenance of our nation’s infrastructure from a safety standpoint (following the Minneapolis bridge collapse) will be spoken about favorably by both parties. We see a large potential positive impact from infrastructure upgrades for bridges (which could benefit Lincoln Electric, Illinois Tool Works, and Kennametal); roads (potentially benefiting Astec Industries, Terex, and Bucyrus International); energy infrastructure (likely aiding Emerson
STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
projects that depend on public funding, especially URS, which does a lot of federal work, including its EG&G unit, which it acquired a few years ago and is completely devoted to federal projects.
Health Care In health care, the most visible topic to date has been the implementation of an allinclusive health insurance program intended to cover the uninsured population. Such a program would likely include direct pricing negotiations between the federal government and drug manufacturers, adversely affecting the pharmaceutical firms. The big winners, in our view, would be the hospitals, because they have been negatively impacted by rising levels of bad debt and the use of emergency rooms by uninsured individuals. Another important election year issue we are tracking is generic biopharmaceuticals. The Democratic candidates have been vocal advocates for the removal of barriers blocking generic drugs and of creating a pathway towards biogeneric approvals at the Food and Drug Administration (FDA). However, there are numerous reasons why we think generic biopharmaceuticals are a distant threat to the U.S. biotech firms. First, these compounds are very difficult to manufacture. They
are produced from human proteins, as opposed to raw chemical ingredients used to make traditional pharmaceuticals, so that plant validations alone would take years. Second, we don’t think the FDA as currently constructed has ample resources, not to mention risk tolerance, to take on a generic biopharmaceutical approval process. In the medical device area, we can’t identify any specific threats from the health care proposals issued by the candidates, and note that the industry is already grappling with the fallout from a wave of high profile product recalls, a more restrictive FDA approval process, increased oversight on physician and patient notifications, increased requirements for post-approval safety studies, and changes to Medicare reimbursements for several important device categories. We think a universal health care insurance plan would benefit the group simply because it would likely be a financial benefit to the hospitals that purchase medical device products.
Energy We believe that a Democratic government may make it easier to pass certain energy legislation, as the perceived favoritism of Republicans towards “Big Oil” would disappear. Ironically, we may see renewed interest
TOP ELECTION PICKS COMPANY NAME / TICKER ● ●
Hologic / HOLX Lincoln Electric / LECO Mindray Medical / MR Noble / NE Terex / TEX
BB+ NR B B-
High Medium Medium Medium High
Growth Growth NA Growth Growth
12-MONTH TARGET PRICE
64 71 41 53 64
75 91 54 66 78
29.1 13.7 45.6 7.8 9.5
Nil 1.4 Nil 0.3 Nil
●Master List issue. *Based on our analysts' assessment of qualitative factors, including financial strength, potential share volatility, competitive position, industry cyclicality, regulatory/legal issues, and other factors. ‡See definitions on page 6. †Based on S&P estimated fiscal 2008 earnings. NA-Not available.
MARKET CYCLES YEAR OF AVERAGE S&P 500 % CHG. PRESIDENTIAL (WITHOUT DIVIDENDS 1945-Q3 '07) CYCLE Q1 Q2 Q3 Q4
in opening up areas for domestic drilling, which could drive up demand for drilling rigs. This also supports a bipartisan interest in decreasing reliance on foreign sources of crude oil and natural gas. Democrats would likely encourage greater use of ethanol, biodiesel, and fuel-efficient vehicles with financial incentives, and greater R&D. One version of a proposed alternative energy bill has the mandated amount of ethanol derived from corn doubling to 15 billion gallons per year from 7.5 billion gallons, but given what this would do to corn prices, we think it will have trouble gaining acceptance. The same bill calls for 20 billion gallons per year of cellulosic ethanol, which is a non-cornbased form that, as yet, doesn’t have viable technology to produce it. Democrats could pursue a climate change bill, but the caucus is divided over the pursuit of nuclear power. One area where Democrats could pursue Big Oil with vigor is on the topic of price levels. It’s conceivable that legislators could hold hearings on prices — especially if we have a cold winter following the election in November 2008. Lastly, it’s very possible that whoever wins the 2008 election will pursue higher royalties or taxes from energy companies.
Consumer Discretionary Regardless of which party gains the White House, advertisers will likely be the big winners, as spot TV advertising spending is projected to rise 9% to 10% in 2008, according to the Television Bureau of Advertising. ■
6 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
If Taxes Rise, Tax Free Applies Municipal bonds and bond funds can help defray some of the impact of rising taxes. New York lawmaker Charles Rangel says he wants to help the middle class by doing away with the alternative minimum tax (AMT), a part of the tax code so complicated that most people can’t definitively say how and to whom it applies. But this much is known. According to the Tax Policy Center, a joint venture of the Urban Institute and the ANNUAL Brookings Institution, the FORECAST AMT is expected to affect about 32.4 million U.S. taxpayers in 2010, up from a mere 3.6 million in Lisa Sanders Managing Editor 2006. In 2006, the tax generated $23.9 billion in revenues for government coffers. In 2010, it should bring in $117.4 billion. Rangel, the chairman of the U.S. House of Representatives Ways and Means Committee, has introduced legislation that would, among other things, repeal the AMT. To offset the loss of revenue, Rangel has proposed raising taxes in other areas, which would primarily affect those with household incomes above $500,000, according to the Tax Policy Center. “Rangel’s goal is an honorable one,” says Dan Loughran, a portfolio manager and the team leader of Oppenheimer Funds’ 18 tax-free bond funds. “The AMT is extremely complicated and poorly designed from the start. It is not doing what it was designed to do, which was basically to prevent a small number of people, 150 or so, from paying no taxes at all. But now, it affects more people in high tax states, like New York and New Jersey, and it’s creeping down the income bracket.” Loughran expects taxes to rise after the presidential election, regardless of whether Rangel’s bill is successful. He points out that Democrats have control of both House and Senate, and he expects them to maintain that
edge post-election. What’s more, Democratic candidates for president have ambitious spending plans: John Edwards wants health care for every American (pegged at up to $120 billion by some estimates). Barack Obama would like to spend $150 billion on developing alternative energy and creating new jobs. All of this costs money, and it’s more likely to come from an increase in taxes, rather than a cutback in spending, Loughran says. “The easiest thing for Congress to do is to let Bush tax cuts expire in 2010, which would be a de facto tax increase,” Loughran says. That is widely expected to happen. And that’s when tax-free securities can become an even more valuable part of a diversified portfolio. According to Loughran, people invest in muni bonds for diversification, because they like the lower volatility that comes with a taxexempt instrument, and because munis provide tax-free income. Oppenheimer even offers bond funds that are AMT-free, such as the Oppenheimer AMT-Free New York Municipals fund (OPNYX), triple tax-exempt for New York state residents, and the Oppenheimer AMTFree Municipals fund (OPTAX). Steven Permut, portfolio manager of the American Century High-Yield Municipal fund (ABHYX), agrees tax rates are almost certain to rise, no matter who triumphs in the November 2008 election. “That’s going to make munis even more compelling as an investment,” he says. “Investment grade munis have a default rate of 0.1% — practically zero — and munis have a lower default rate than corporates of similar ratings. What’s more, the correlation between the economy and default rates is very weak. Even if the economy goes into recession, default rates will not go up.” ■
Standard & Poor’s The Outlook EDITORIAL Vice President, Editorial James Holloway Managing Editor, U.S. Editorial Beth Piskora Managing Editor, The Outlook Lisa Sanders Senior Editor Kimberly A. Castro Statistician Chris Peng O P E R AT I O N S Managing Director, Product and Business Development Robert Barriera Vice President, Product Management and Development Peter Fiore Vice President, Data Operations Frank LoVaglio For customer service, please call 1-800-852-1641 between 9am and 4pm Eastern Time, Monday through Friday.
The Outlook (USPS 415-780, ISSN 0030-7246) is published weekly except for April 11, July 11, September 26, and December 26, 2007 by Standard & Poor’s, 55 Water St., New York, NY 10041. Annual subscription: $298. Periodicals postage paid at New York, NY, and additional mailing offices. POSTMASTER: Send address changes to The Outlook, Standard & Poor’s, 55 Water St., New York, NY 10041. Copyright ©2007 by The McGraw-Hill Companies. Reproduction in whole or in part prohibited except by permission. All rights reserved. Officers of The McGraw-Hill Companies: Harold W. McGraw, III, Chairman, President and Chief Executive Officer; Robert J. Bahash, Executive Vice President and Chief Financial Officer; John Weisenseel, Senior Vice President, Treasury Operations; Kenneth M. Vittor, Executive Vice President and General Counsel. Because of the possibility of human or mechanical error by S&P’s sources, S&P, or others, S&P does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.
The Outlook is a publication of Standard & Poor’s Investment Services. This department operates independently of, and has no access to, non-public information obtained by Standard & Poor’s Ratings Services, which may in its regular operations obtain information of a confidential nature. Information included in The Outlook may at times be inconsistent with information available in S&P’s MarketScope, an electronically delivered online service.
S&P EVALUATION SYMBOLS STARS Rankings Our evaluation of the 12-month potential of stocks is indicated by STARS: ±±±±± Strong Buy—Total return is expected to outperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares rising in price on an absolute basis. ±±±± Buy—Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis. ±±± Hold—Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis. ±± Sell—Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain. ± Strong Sell—Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis. NR Not ranked.
Quality Rankings (QR) Our appraisals of the growth and stability of earnings and dividends over the past 10 years for STARS and other companies are indicated by Quality Rankings: A+ Highest B+ Average C Lowest A High B Below Avg. D In reorganization A- Above Avg. B- Lower NR Not Ranked Quality Rankings are not intended to predict stock price movements.
STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
High-yield bonds could be a good investment in 2008, as investors shake off their aversion to risk. Junk just ain’t what it used to be. Year-to-date through November 15, high-yield bonds returned 3% vs. a total return of 7.7% for U.S. Treasuries. The relative outperformance of Treasuries can be attributed to many investors’ flight to safety in 2007. But in 2008, many market prognosticators are expecting a much better year for high-yield bonds. An intriguing analysis by T. Rowe Price and JP Morgan shows that so-called problem industries — financial services, retailers, housing, and consumer products — represent only 13% of the highyield asset class. (See chart.) The sectors that represent the most — energy, utilities, and health care — “should be resilient even if the economy slows,” says Mark Vaselkiv, manager of the T. Rowe Price High Yield (PRHYX) fund. What’s more, he’s very excited that “world-class companies like Alltel, Texas Utilities, and First Data Securities are entering the high-yield market.” To be sure, the outlook for high-yield bonds will depend on the overall health of the U.S. economy in 2008, he says. “We could see strong returns if the current financial services crisis stabilizes,” and there isn’t a recession, he states. “If the crisis continues and we head into a recession, however, spreads would widen further and performance would be more constrained.” David Wyss, the chief economist for Standard & Poor’s, pegs the recession risk at 40% over the next 12 months. He acknowledges that U.S. housing weakness and high energy prices, along with billions in writedowns at financial institutions, have sparked fears of slowing employment and wage growth among investors. Although Wyss expects U.S. gross domestic product growth to slow significantly over the next three quarters, he expects a recession to be avoided. He predicts growth will bottom at 0.7% in the first quarter of 2008.
Beth Piskora Managing Editor, U.S. Editorial
But what happens if prognosticators are U.S.-based issuers have defaulted so wrong? Vaselkiv doesn’t see a jump in far this year. default rates unless corporate credit “Typically at the inflection point in the quality significantly deteriorates. credit cycle, a higher range of variability The yield advantage of high-yield surrounds the forecast and our optimistic bonds should provide a cushion in the and pessimistic projections indicate a low event of a rise in defaults, he says. forecast of 2.4% and a high of 4.4%,” As of the end of November, the Merrill Vazza says. “A low forecast would be Lynch High Yield 100 index offered a consistent with a default count of 39 yield of 8.528%. By contrast, the 10-year (there were 21 in 2006), whereas a high Treasury was yielding 4.025%. *CORPORATE HIGH-YIELD MARKET S&P Ratings Services, which Energy 8.6% Utilities 7.9% operates indeHealth Care 6.5% pendently from Transportation 6.3% Service 6.0% S&P Equity Information Technology 5.6% Research, believes Metals/Minerals 5.3% default rates will Gaming/Leisure 5.3% Financial 5.0% remain below hisForest Products 4.9% torical levels. Diversified Media 4.6% Cable/Wireless Video 3.9% “The U.S. Chemicals 3.9% speculative-grade Wireless 3.6% default rate Wireline 3.4% Food/Tobacco 3.3% remains supRetail 3.2% pressed and is Manufacturing 2.8% Housing 2.5% likely to post a Consumer Products 2.2% year-end, 25-year Aerospace 2.1% Broadcasting 1.8% low of close to Food and Drug 1.5% 1%,” says Diane 0% 2% 4% 6% 8% 10% Vazza, a managSource: T. Rowe Price, JP Morgan. *Percent of asset class. ing director for S&P Ratings Services. “In the next several quarters, we forecast would require 72 defaults. We expect the default rate to escalate based currently have 74 issuers that are weakest on the cumulative impact of the changes links — those rated B- or lower by us in the credit-pricing environment.” with a negative CreditWatch listing or a Vazza also cites the slower pace of eco- negative outlook.” nomic growth for the potential uptick in There are many mutual funds spedefault rates. She expects default rates to cializing in the high-yield corporate bond accelerate in the second half of 2008 and market. Screening for those with a recinto 2009, and she estimates a speculaommendation from S&P Fund Services, tive grade default rate of 3.4% by the a minimum initial investment of less than end of October 2008. Although that’s $10,000, and no front-end load, The higher than current levels, it is lower Outlook identified these funds: Fidelity than the 4.5% historical average. Capital & Income (FAGIX), Fidelity Putting that default rate prediction High Income (SPHIX), T. Rowe Price into context, it means 56 issuers High Yield (PRHYX), and USAA Highmust default. By contrast, only 14 Yield Opportunities (USHYX). ■
8 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
2008 International Outlook S&P expects international stocks to post positive returns in 2008, but a more difficult economic environment is likely to subdue performance and increase volatility. Standard & Poor’s expects the best equity performance to once again come from emerging markets (EM). In Europe, a 7% to 9% gain is likely, while we forecast only 1% to 3% appreciation in Japanese stocks.
Looking into 2008, economic expansion is likely to slow in Europe and the United Kingdom, as slowing U.S. growth threatens exports, in our view. In addition, continued euro and sterling appreciation vs. the U.S. dollar is expected to add additional export pressure, especially early in the when we expect ANNUAL year the greenback to be at FORECAST its weakest. Tightening credit conditions and high oil Alec Young prices will slow domesInternational Equity tic consumption. Strategist However, S&P expects only slowdowns, not recessions, since growing European trade with emerging market economies should help offset weakness elsewhere. We forecast 2008 Eurozone gross domestic product (GDP) growth will decline to 1.9% from the 2.7% estimated for 2007. Similarly, we expect U.K. GDP growth to decline to 2% next year from the 2.8% expected in 2007. We find European equity valuations very attractive. The S&P Europe 350 index is trading at only 12.2 times 2008 earnings estimates. And though we expect economic growth to decelerate, corporate profits should continue to improve. The consensus expects 8% growth for the S&P Europe 350 in 2008. Lastly, the index sports a dividend yield of 3%, which bolsters its total return potential.
Europe and the United Kingdom represent about two-thirds of developed international market capitalization. We recommend a 22% weighting to this asset class for growth oriented investors, 16% for moderate investors, and 13% for conservative investors. The MSCI-EAFA (EFA) tracks the MSCI Europe, Australasia, and Far East index.
S&P believes lackluster Japanese equity performance is likely to continue in 2008. Japan comprises 20% of the MSCI Europe, Australasia, and Far East index. Japan’s exports are likely to suffer amid slower U.S. (22% of exports) and European (15% of exports) growth and a modestly stronger yen. In addition, we think rising unemployment and weak wage growth will continue to pressure domestic consumption. Global Insight, an independent forecasting firm, expects Japanese GDP growth to slow to 1.3% in 2008 from 1.9% forecasted for 2007. High valuations only exacerbate investor anxiety. The S&P Topix 150 trades at 15.7 times 2008 consensus estimated earnings, a significant valuation premium to other developed markets like the United States, which trades at 14.5 times, and Europe, which trades at 12.2 times. In addition, estimated 2008 Japanese consensus earnings growth is no higher than that of most other developed equity markets. On the currency front, U.S. investors face a Catch-22. While dollar-denominated returns suffer when the yen weakens vs. the greenback, our analysis indicates yen strength leads to exporter P/E contraction, which undermines any currency benefit. A case in point is 2007. While the yen’s year-to-date rally vs. the
greenback has boosted dollardenominated Japanese stock returns, the market remains down for the year in light of a sharp selloff in exporters’ shares.
While we expect increasing intra-EM trade and rising domestic demand to fuel continued strong growth in China, India, Latin America, Eastern Europe, and the Middle East, we expect lingering U.S. recession fears and tighter global credit conditions to limit P/E expansion. While slowing growth and credit related writedowns have led to negative earnings revisions in the United States, Europe, and Japan recently, EM equities continue to enjoy profit momentum. Reflecting strong fundamentals, the consensus expects a 14.9% increase in earnings in 2008. In addition, recent EM equity volatility has left valuations more attractive. Since peaking on October 31 at 14.5 times 2008 estimates, the MSCI EM index’s forward P/E has declined to 13.2, implying an estimated 2008 P/Eto-growth ratio of only 0.88. We expect 10% to 15% price appreciation in 2008. This assumes no P/E expansion, with the index expected to climb roughly in-line with projected earnings growth. S&P thinks EM equities should represent a core, long-term holding for U.S. investors. We recommend an 8% weighting for growth-oriented investors, 4% for moderate, and 2% for conservative. The Emerging Markets ETF (EEM) tracks the MSCI EM index.
Now the world’s fourth largest economy, China has become a focal point of global growth. Its rapid economic expansion is
powering not only developed markets, but the emerging world as well. IntraEM trade, much of which involves China, represented roughly half of all EM exports in 2006, according to the International Monetary Fund and Morgan Stanley data. We believe this has allowed EM GDP growth to largely separate from slowing U.S. growth in 2007. With U.S. GDP now decelerating more rapidly, and Europe and Japan showing signs of slowing as well, China’s continued growth is critical to sustaining strong EM economies and profit momentum. China was one of the best performing EMs through November 30, rising 70.71%. Given major restrictions limiting foreign investor access to the local Chinese equity markets, overseas investors invest in China primarily through H-shares (Chinese blue chips listed in Hong Kong). These have lower valuations and higher quality profiles than companies listed solely on the mainland, as a result of a more sophisticated institutional shareholder base and greater regulatory transparency. China currently represents 14.7% of the EM asset class, second only to South Korea’s 15.2%. While H-share gains will likely slow in 2008, the outlook remains relatively bright, with the consensus expecting 31% MSCI China index earnings growth. Although valuations are among the highest in the emerging world at 24 times estimated earnings, we believe this is largely justified by strong growth prospects. The iShares FTSE/Xinhua China 25 Index ETF (FXI) tracks leading Chinese H-shares.
After rising 59.3% through November 30, Indian equity performance is likely to moderate sharply in 2008. Although we expect positive returns in the year ahead, we believe other EM offers a better risk-reward ratio. While 2008 Indian economic growth is likely to remain strong at 8.7%, India’s high current account deficit could make it more vulnerable to foreign capital outflows if global risk aversion rises, in our view. In addition, S&P
STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
believes that TOP-RANKED ADRs with inflation, 12-MONTH CURRENT TARGET †P/E YIELD credit growth, COMPANY NAME / TICKER *RISK PRICE PRICE RATIO (%) and budget Banco Santander / STD Medium 21 25 10.0 3.0 deficits all eleCredit Suisse / CS Medium 60 80 8.4 2.0 vated, the govIcon / ICLR Medium 56 72 24.1 Nil ernment has Lloyds TSB Group / LYG Medium 38 57 7.9 7.3 less room to ease monetary Mindray Medical Int'l / MR Medium 41 54 45.6 Nil and fiscal poli- Shanda Interactive / SNDA High 36 45 15.9 Nil cy should the StatoilHydro / STO Low 30 44 9.6 1.5 domestic econTeva Pharmaceutical / TEVA Medium 45 51 16.7 0.7 omy weaken. *Based on our analysts' assessment of qualitative factors, including financial strength, potential share From a valuavolatility, competitive position, industry cyclicality, regulatory/legal issues, and other factors. ‡See tion standpoint, definitions on page 6. †Based on S&P estimated fiscal 2008 earnings. high relative valuations of Not surprisingly, given the importance 22 times 2008 estimates appear justified of the energy sector, 2008 consensus by 21% consensus earnings growth estiearnings growth is expected to slow to mates. India represents 7.3% of the 7.8% from 18% in 2007. While Russia’s MSCI EM index. The iPath MSCI forward P/E of 11.8 is relatively low, its India Index exchange-traded notes earnings growth rate is only about half (INP) track the MSCI India index. the asset class average of 14.9%, making RUSSIA outperformance unlikely. Russia represents 9% of the MSCI EM index. Russian equities have underperformed BRAZIL through November 30, rising 17.6% vs. a 36.1% gain for the broader EM universe. From a fundamental standpoint, Brazil, Latin America’s largest equity S&P believes Russia’s outlook is mixed. market, is among the best performHigh oil prices continue to fuel large ing, rising 70.7% through November trade and budget surpluses, helping 30. It now accounts for 12.3% of insulate Russia from foreign capital the MSCI EM index market capitalflight, should global risk aversion escaization, behind only South Korea late. In addition, rising incomes and and China. Record commodity credit growth are boosting household prices have fueled a trade surplus, consumption, which is supporting servlowered inflation, and strengthened ice and manufacturing expansions. As a sovereign credit ratings, giving the result, the economy is expected to grow central bank the leeway to continue 7.5% in 2007. easing monetary policy. However, we believe slow growth in Brazil currently trades at 12.5 times the nation’s biggest sector is clouding 2008 earnings estimates. Given that the economic outlook. Global Insight improving fundamentals have expandforecasts a slowdown to 6.6% GDP ed the multiple, we believe it is justigrowth in 2008. Oil and gas producers fied. Looking ahead to 2008, the econare no longer able to expand at the omy is expected to grow 5.1%, up rates recorded several years ago, makslightly from this year’s 4.9% forecast. ing slower growth inevitable. Natural In addition, the consensus expects gas output was flat in the first half of earnings growth of 9.1% in 2008. 2007, while annual oil output growth While returns will inevitably moderate was only 3.2%. As a result of years of from this year’s torrid pace, we expect gains to continue. The iShares MSCI under-investment, the gas industry is Brazil Index ETF (EWZ) tracks the expected to struggle to meet rising MSCI Brazil index. ■ domestic demand.
10 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
Sector Signposts for 2008 S&P Equity Research analysts provide their expectations for the year ahead. CONSUMER STAPLES While S&P forecasts a slowdown in U.S. economic growth in 2008, we expect spending on consumer staples items, such as food, beverages, and household products, to remain steady. However, we anticipate some challenges from higher commodity prices and shifts in consumer preferences. In response, we expect that businesses will continue to focus on cost reductions and new products. Also, we expect that various companies will pursue growth ANNUAL opportunities in developFORECAST ing overseas markets, such as Russia, China, and India. In 2008, further weakness in the value of the U.S. dollar should generally help the financial results of U.S. companies that have a sizeable amount of sales from overseas markets.
CONSUMER DISCRETIONARY With advertisers spending more on Internet advertising, we expect traditional media companies to focus even more on new media initiatives. This is probably more critical to publishers, who are facing sharp declines in classifieds and circulation. For automobile manufacturers, the general economic condition is highly critical. Since S&P expects real gross domestic prod100 uct (GDP) growth to slow in 2008, new 96%
light vehicle sales should decline from 2007. Auto retailers will work to offset pressured margins for new vehicles with more and higher margin sales of used vehicles, finance and insurance offerings, and parts & services business. S&P expects retailers to be affected by a slowdown in consumer spending, given rising energy and food costs and higher mortgage payments. ENERGY We see crude oil and natural gas prices rising in 2008, and with volumes up on project startups, we expect exploration & production earnings to improve modestly. However, refining margins are expected to narrow considerably. Energy companies will continue to spend on E&P projects in the deepwater, and in frontier international regions with high growth, but North American natural gas projects may be postponed. For services and drilling companies, we think the trend towards more activity in the Eastern Hemisphere will continue. In the ethanol industry, we see more consolidation, unless the government dramatically increases its ethanol mandate, which would boost demand. There are tremendous expansion plans afoot in this area by many competitors, which could force prices even lower. FINANCIALS S&P continues to have a negative fundamental outlook for the regional *BEST INDUSTRIES
banking, thrifts and mortgage finance, consumer finance, and other diversified financial services industries. We are concerned that weakening credit and necessary additions to reserves for loan and lease losses will outweigh expected improvements in lending margins. We anticipate investment banks will also be faced with additional writedowns of their mortgage-related assets, although a number of other business lines should continue to grow, and should benefit from increasing international business. We also continue to have a negative outlook on the property casualty insurance industry for 2008. We are neutral on the life and health insurance industry, given S&P’s 40% recession-risk estimate. A recession may curb the demand for some products and lead to higher loss ratios for some disability products. HEALTH CARE Our fundamental outlook on the health care sector remains neutral. We think the group will generate nearly 14% earnings growth in 2008, which compares favorably with GDP growth projections, but is in line with the earnings estimate for the S&P 500. For pharmaceuticals, we think the 2008 outlook for drug stocks is clouded by uncertainty about the impact of next November’s elections, projected flat Medicare Part D volume, and relatively sparse R&D pipelines. On the plus side, we still think companies with well-defined growth prospects and generous dividend yields should hold up relatively well. We believe the health care equipment group 60% 45%
0 Fertilizers & Agri. Chem.
Diversified Metals & Mining
Construction & Engineering
*2007 equity performance through December 7.
Coal & Consumable Fuels
Oil & Gas Equip. & Svcs.
STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007 *WORST INDUSTRIES
Broadcasting & Cable TV
Publishing & Printing
Home Improvement Retail
Real Estate Mgmt. & Develop.
Thrifts & Mortgage Finance
26% *2007 equity performance through December 7.
should benefit from a recovery in demand for implantable defibrillators, and ongoing strength in the cardiology, diabetes, pain management, and orthopedics markets should boost sales and earnings in 2008. INDUSTRIALS Though S&P expects economic growth to slow in the United States and Europe, we think the global economic performance should stay strong enough to allow some industries to fare well in 2008. We remain most positive on the same categories that we have favored for some time now, including companies that sell commercial construction equipment (part of construction & farm machinery & heavy trucks), as well as industrial machinery companies and the aerospace portion of the aerospace & defense industry. Both commercial construction and industrial machinery serve clients with major international exposure to growing end-markets, such as infrastructure and other commercial construction, oil and gas, and aerospace. Aerospace stands to benefit from high orders for planes, predominantly in foreign markets. MATERIALS The housing market is the key factor for the forest products industry. We see further declines in lumber demand in 2008. The outlook is a little better for paper products — even though demand is sluggish, capacity reductions ought to enable pricing improvements. We are cautious on the chemicals industry since we expect volumes to rise only 1% and see lower demand from housing and auto markets in the United States. In steel, we see distributors rebuilding inventories, a decline in imports, and an uptick in steel demand from nonresidential construc-
tion. Higher steel prices in 2008 should generate increases in sales and earnings. For gold, we expect prices to rise on the expectation of a further decline in short-term U.S. interest rates, gold production, and the value of the U.S. dollar. For other base metals, like copper, we have cut our price expectations for 2008. We saw unusually strong demand for copper from China in 2007, which we don’t expect to recur. TECHNOLOGY S&P has a positive fundamental outlook on the tech sector, which reflects our view of decent prospects at home and strong demand abroad, particularly for PCs. We also expect companies to increasingly focus on improving shareholder value through restructurings and stock repurchases. For semiconductor companies, we expect to see both earnings and revenue growth in 2008, but we are cautious on valuations, and believe these and other considerations could cause valuations on higher-volatility stocks to fall further. We have a positive outlook on the systems software industry, largely reflecting our views about Microsoft. However, we see weakness in North America, and decelerating growth related to Linux. Computer-related companies should enjoy 10% unit growth, as the global transition to wireless continues and more people adopt the latest operating systems from Microsoft and Apple. Storage-related firms, particularly those with exposure to Asian markets, should do well. TELECOM We are positive on the telecom services industry, since we expect the carriers, through broadband growth and cost savings, to generate strong free cash flow to support dividends (currently an
above 47% average 53% -50 3.1% yield) and share buy-60 backs in 2008. While we expect to see some pressure from cable telephony and the weak housing market, we contend that bundled telecom services will remain core to consumers. We believe that cash flows at independent wireless service providers in developed countries will be stable, but they could see margin pressure, as competition continues to intensify through price cuts, incentives, and handset subsidies. We believe wireless providers in emerging markets should fare better in terms of improving margins and profitability, but we do expect competition to begin to have an impact. UTILITIES We expect utility stocks to show more muted gains in 2008, after outperforming in 2007, but they should benefit from another year of volatility in the broader market, and the sector should remain a safe haven. An average dividend yield of 2.9% looks favorable, particularly in a lower interest rate environment, but the stocks could fall into disfavor if Treasury yields were to rise sharply. On a fundamental basis, we see increasing profits for the electric utilities from rate increases, additional revenues from expanded transmission operations, and higher wholesale power margins (as expiring power contracts are renewed at higher prices). While we remain neutral on the sector as a whole, we are positive on those companies that have a strong position in the wholesale power market. An economic slowdown could have an adverse impact on utilities serving heavily industrial regions. ■
12 STANDARD & POOR’S THE OUTLOOK DECEMBER 19, 2007
Building a Well-Balanced Portfolio
This portfolio affords diversification among major industry groups. Investment pros frequently use the S&P 500 as a benchmark when constructing a diversified portfolio. The “500,” which is market-value weighted, includes 10 sectors and more than 100 industry groups. Each stock’s weighting in the index is determined by multiplying the number of shares outstanding by the current share price. The sample portfolio below is
year. (Following the sector name in the table, the first figure in parentheses represents the sector’s approximate weighting in the S&P 500; the second figure is our suggested weighting.) Choices from The Outlook’s Master Lists were used wherever possible. Otherwise, we looked for stocks with high Quality Rankings. Performance of the portfolio is not tracked. ■
broadly representative of the S&P 500, though we have also included some mid-cap names for capitalization diversification purposes. We have adjusted the sector weightings to reflect S&P’s investment policy and economic projections, so we expect the 20-stock list (composed entirely of stocks ranked four and five STARS) to outperform the index in the coming
PORTFOLIO BASED ON SUGGESTED SECTOR WEIGHTINGS SHARES COMPANY NAME / TICKER
140 65 65 65 85 160 130 100 45 65 150 70 150 70 125 140 60 55 310 90
CONSUMER DISCRETIONARY (9%, 8%) Home Depot / HD ● McDonald's / MCD CONSUMER STAPLES (10%, 10%) ● Altria / MO ● Procter & Gamble / PG ENERGY (11%, 11%) Sunoco / SUN ● Superior Energy / SPN FINANCIAL SERVICES (19%, 17%) ● Bank of America / BAC ● Chubb / CB ● Franklin Resources / BEN HEALTH CARE (12%, 13%) ● Johnson & Johnson / JNJ Schering-Plough / SGP ● UnitedHealth Group / UNH INDUSTRIALS (12%, 12%) ● Carlisle / CSL W.W. Grainger / GWW INFORMATION TECHNOLOGY (16%, 18%) ● Automatic Data Processing / ADP ● Citrix Systems / CTXS ● International Business Machines / IBM MATERIALS (3%, 3%) ● Airgas / ARG TELECOM SERVICES (4%, 4%) Citizens Communications / CZN UTILITIES (4%, 4%) ● Nicor / GAS Total
5 5 4
A B+ A-
Low Medium Low
L-Blend L-Blend L-Growth
47 55 122
6,110 5,500 5,490
333 116 27
5.4 2.1 0.5
10.6 8.6 15.1
51 65 155
4 5 4
Low High Medium
L-Growth L-Blend L-Growth
68 30 58
4,420 4,500 4,060
108 39 2
2.4 0.9 0.1
15.6 18.8 14.7
74 37 62
5 5 5
A+ B+ A
Medium Medium Medium
L-Growth L-Growth L-Growth
47 39 110
5,875 5,460 6,600
145 0 96
2.5 Nil 1.5
21.8 25.0 13.6
56 50 138
●Master List issue. *Based on our analysts' assessment of qualitative factors, including financial strength, potential share volatility, competitive position, industry cyclicality, regulatory/legal issues, and other factors. ‡See definitions on page 6. †Based on S&P estimated fiscal 2008 earnings. L-Large cap. M-Mid cap.