S&P: Time to Play Defense

Standard & Poor's has downgraded cyclical sectors such as IT in favor of traditionally defensive groups such as consumer staples. Here's a rundown

On Jan. 9, Standard & Poor's Equity Strategy Group embraced a more defensive view of the market by upgrading the traditionally defensive sectors and downgrading the traditionally discretionary/cyclical sectors. Specifically, we upgraded Consumer Staples, Health Care, Energy, and Utilities to overweight from marketweight; downgraded Information Technology to underweight from overweight; and downgraded Industrials to underweight from marketweight.

Here is a rundown of S&P's views of the sectors in question:

Consumer Staples
Raised to overweight from marketweight

With investor risk aversion rising amid slowing economic growth, we believe the sector's predictable revenues, low beta, above-average international exposure, and 2.3% market-cap weighted dividend yield will allow it to outperform. In addition, the sector boasts a high average market cap, which positions it to "favorable," given investors' ongoing large-cap growth orientation, in our view.

Energy
Upgraded to overweight from marketweight

While S&P forecasts that prices for the benchmark West Texas Intermediate grade of crude oil will average near $76 per barrel in 2008, we believe there is risk prices will remain elevated throughout the year. As a result, we believe the Energy sector's earnings-per-share growth is unlikely to be negatively revised, despite heightened EPS risk for the broader market. In addition, the Energy sector trades at only 12.4 times our 2008 estimated sector EPS, the second lowest price-to-earnings (p-e) valuation in the S&P 500 index. We also think the sector stands to benefit from increasing inflation pressure, rising geopolitical unrest, and continued U.S. dollar weakness.

Health Care
Raised to overweight from marketweight

Following an increase by S&P Economics in its perceived recession risk to 50%, and with several U.S. equity benchmarks recently closing below mid-2007 lows, we recommend investors increase exposure to traditionally defensive sectors such as health care, because of the relatively static demand for their products and services. We believe companies with well-defined growth prospects and generous dividend yields should hold up relatively well. We think the sector's predictable revenues, low beta, and above-average international exposure will allow it to outperform other groups on a relative basis.

Industrials
Downgraded to underweight from marketweight

With the U.S. economic slowdown accelerating and mid-cycle slowdowns now under way in Europe, Britain, Canada, and Japan, we believe this cyclical sector is vulnerable to a contraction in its p-e multiple as investors increasingly question the prospects for its future EPS growth. While S&P analysts currently forecast a 10% gain in 2008 EPS for the Industrials sector, we believe this may be revised lower should global growth continue to slow. In addition, the sector's valuations are relatively high, given that we are late in the current economic cycle.

Information Technology
Downgraded to underweight from overweight

Slowing global economic growth is fueling heightened risk aversion, making a repeat of the IT sector's strong 2007 outperformance unlikely, in our view. In addition to the U.S. economy flirting with recession, mid-cycle slowdowns are now under way in Europe, Britain, Canada, and Japan, which we think undermines the benefit the sector derives from its 55% international sales exposure. Also, the sector's 18.1X p-e ratio is the highest in the S&P 500, leaving little room for earnings disappointments, in our view. We believe 2008 EPS estimates for this sector will be revised lower in the months ahead.

Utilities
Raised to overweight from marketweight

Since S&P Economics has raised its perceived risk of a recession to 50%, and several U.S. equity benchmarks recently closed below summertime lows, we see more downside price action likely and think a more cautious approach is prudent. We recommend investors increase exposure to traditionally defensive sectors, such as utilities, because of relatively static demand for their services. S&P analysts see 2008 operating EPS for the sector rising 12%, and we believe the sector's 2.9% dividend yield, second highest among the 10 sectors in the S&P 500, will offer additional support.