Looking to Sectors for Relief

March 13, 2001 -- While investors may be pondering which companies will follow their brethren into the meat grinder that is the market, the more important question might be which companies won't.

One key factor is the interest rate. If the overall economy slows further, ongoing Federal Reserve rate cuts will likely produce a list of retail and financial services stocks that will benefit most from the softer stance on monetary policy.

Footwear, health care, oil and gas (drilling & equipment), beverages, and electronics/semiconductors consistently outperformed during the three, six, and 12-month periods during Fed easings in 1987, 1989, 1995, and 1998, according to the ISI Group, an advisory firm that tracks such data.

For instance, footwear produced an average return of 45.5 percent; communications equipment posted an average return of 37 percent; and retail gave investors a 35 percent return, all in the one-year period following rate cuts in October 1987, June 1989, July 1995, and September 1998.

Old Reliable?

Some money managers, though, are wary of sectors that have been havens in the past. "For the past six months, there's been a reallocation from tech stocks. Investors have been hiding in value and Dow stocks," says Kyle Rosen, a hedge fund manager with an eponymous operation based in Southern California. "Today that notion was crushed. Stocks that had been favored fell out of favor today."

Other managers, however, say they've returned to following the muse of Warren Buffett. "You look at the tape and the sectors you want to be in are the oldest of Old Economy," says one New York hedge fund manager who requested anonymity, tossing off names of his holdings that include Allstate, Philip Morris, Vornado, and Pepsico.

Utilities, oil and gas, and consumer staples are the kinds of sectors that investors will be looking for, hunting stocks that look inexpensive based on their price-to-earnings ratios and pay sweet dividends.

Scoring Drugs

In most times of market turbulence, investors think of drug stocks much like they think of the Baltimore Ravens: great defense. The reason is simple — people get sick no matter what the economy is doing so they'll still have to buy drugs.

But the stocks have had a rough 2001. For instance, Merck has fallen about 21 percent, while Eli Lilly has tumbled 16 percent and Pfizer has dropped 12 percent. On Monday, Merck slipped $1.54, or 2 percent, to $74.15, Lilly dropped 50 cents, or 0.63 percent, to $78.50, and Pfizer fell $2.10, or 4.9percent, to $40.35.

But there are indications that investors may return to at least some drug stocks as they run from tech issues.

In a report released Monday, SG Cowen noted that Pfizer and Pharmacia offer high earnings growth rates with the most promising new products among the drug makers, "regardless of the backdrop."

Pfizer's earnings per share are projected to climb 27 percent this year, while Pharmacia's are expected to climb nearly 21 percent, according to figures from First Call/Thomson Financial. SG Cowen also called Merck a "compelling value play." It trades at about 23 times this year's projected earnings, below Lilly at about 28 times and Pfizer at 31 times. But the firm also warned that it expects the group to "mark time" with the S&P 500 this year.

Shopping for Gains

Retail shares, which have held up relatively well amid the carnage in the tech sector, lost plenty of ground Monday.

In stark contrast to the Nasdaq, the S&P Retail Index is up over 20 percent since mid-October and up 6 percent from a year ago, when the tech sector began to crumble. That record didn't help in Monday's selloff. The S&P Retail Index ended the day down almost 4 percent, with J.C. Penne, Gap and Wal-Mart all mirroring that decline.

Now what? "I think you have to be selective and look for turnaround," said Himali Kothari, retail analyst for the John Hancock Small Cap Growth Fund. "If there is an interest rate cut next week it will probably help everybody."

The second half of 2001 could bring the sector a boost from better year-on-year comparisons for sales and earnings, which began to drop off in the second half of last year. That will make it easier this year for companies to show strong monthly gains. Also, retailers are among the top performers amid falling interest rates.-

Banking on a Rate Cut

In looking at all rate cuts since 1971, Standard & Poor's senior investment strategist Sam Stovall concluded that the best-performing sector is consumer staples — such as drug stores and food-chain stocks — a group that has risen an average of 16.2 percent in the six months following a cut. Since Jan. 3, the Fed has twice cut rates, and most analysts suspect further cuts are in the works.

But not everyone is convinced. "I'm looking at other areas outside of retail currently," said David Brady, an ex-retail analyst and manager of the $1.3 billion Stein Roe Young Investor Fund. "I think it's had its run, and that the fundamentals are fully reflected in their stocks."

The wave of selling that swept the market Monday soaked the financial sector in red with a broadside that spared no one, and put even greater pressure on brokerage stocks.

The Philadelphia Stock Exchange/KBW Banks Index, which tracks the country's 24 largest banks, sank 43.85, or 5 percent, to 843.67, while the American Stock Exchange Broker/Dealer Index lost 30.94, or 6.4 percent, to 452.11.

"I didn't see any news other than the weakness in Japan. It continues to be distressing but I don't think it was particularly surprising," says Brock Vandervliet, banks analyst at Lehman Brothers.

Indeed, what news there was on the financial sector Monday tended to lean toward being upbeat. Salomon Smith Barney banks analyst Ruchi Madan penned a "mini" first-quarter preview this morning saying "most banks look good or OK." Madan said the March 20 Federal Reserve meeting and upcoming quarterly results could be positive catalysts for the sector and predicted bank stocks would "continue to outperform."

But banks in the "good" and "weak" camps alike were whacked with similar gusto. Woells Fargo, considered one of the good ones, lost $2.69, or 5.3 percent, to $47.80. Meanwhile FleetBoston FInancial, which Salomon thinks could miss the consensus estimate, lost $2.77, or 7.2 percent, to $35.95.

In a report on mid-cap banks, Vandervliet and fellow Lehman bank analyst Jason Goldberg homed in on a number of companies they regard as "growth names" including City National and TCF Financial which are rated as strong buys because the Lehman analysts think they should benefit from "lower rates and have competitive advantages in their markets."

Brokers were pressured even more, perhaps not so surprising given all of the nervousness about falling investment revenue, a bone-dry underwriting pipeline and slipping trading profits. Goldman Sachs lost $4.51, or 5.2 percent, to $82.49, while Morgan Stanley Dean Witter sank $5.26, or 8.6 percent, to $56.

"Tech may have a little more downside but it seems the rest of the [S&P 500] and the financials might have finally capitulated," said Scott Edgar, director of research at Walnut Creek, Calif.-based SIFE Trust Fund, which specializes in financial service stocks.

"At the very least there is probably a trading rally down the road pretty soon," Edgar said, noting that the financial sector and the broader market have been having a number of bad days lately. "Today, of course, is the topper of them all."

Network Sector: Anywhere but Here

The full-bore buildout of the new Internet has slowed to a crawl, and taken the entire networking sector down with it.

The once-bulletproof optical-equipment makers that develop gear for fiber networks such as Nortel, Sycamore, Corvis and ONI have dipped to or near their 52-week lows. Ciena has been the only member of the pack to serve as an exception to that trend, as investors are sweet on its growing list of customers and range of products.

In the optical-component sector JDS Uniphase and Corning both hit new 52-week lows Monday as investors have sold these shares with impunity.

With telecom service providers running short of cash to buy equipment, suppliers such as Lucent, Cisco and Nortel have been moving less gear and needing fewer lasers and other components from JDS and Corning. Hence the recent profit warning, or in JDS' case warnings (three of them) so far this quarter.

The phone companies all headed into their slide much earlier in this downturn that the networking side as overspending and underselling took their toll.

Generally speaking, shares of the telecom underdogs Level 3, Global Crossing, Metormedia Fiber and Williams Communications continue to sag as they're forced to pour far more money into their networks than they reap.

Established players, quasi-monopolies such as Verizon, SBC, BellSouth and to some degree Qwest, have — relatively speaking — retained a fair portion of their share prices. Conventional wisdom says that these companies have to exert less, by way of competitive spending, to hold their ground.

And these days, holding your ground seems good enough.