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Last Update: Technology
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Health Care typically holds up during an economic slowdown due to the sector's inherent defensive characteristics. This hasn't been the case this year until just recently. Health Care tumbled nearly 18% from January to June as costs mounted, growth slowed, and concerns over the impending change in Washington took hold. Just recently, however, Health Care has been a primary benefactor of the rotation out of commodities and energy. The S&P 500 Health Care sector has rallied nearly 10% from the end of June.
The Market Weight rating reflects enduring challenges facing large-cap pharmaceutical companies of slowing pipelines, drug price deflation, and rising patent expirations. Other areas of concern include rising health care costs and potential managed care reimbursement policies with a new administration. There are some industries that we continue to think offer compelling growth opportunities including Biotechs, which have robust pipelines and are in the midst of a M&A cycle, and Medical Equipment. Managed Care companies have also finally gotten a better handle on pricing and costs. Some names we like include JNJ, AET, ESRX, ALXN, CELG, SQNM, and THOR.
Archive As the economy recovers, interest rates will rise and investors will start to seek more competitive yields outside this dividend sector. The sector has already seen this occur, falling from multi-year highs at the end of 2007. We see further downside risk ahead and recommend investors start paring back positions. ArchiveThe Consumer Discretionary sector was the second-best performing sector over the past week
The perils of the discretionary sector are well known and, we would argue, fully discounted into valuations. A housing market recession, consumer credit concerns, and high food and fuel costs have pushed the discretionary sector to 2003 lows.
There is no doubt the American consumer is facing challenging economic times. That being said, valuations have been steeply discounted and the U.S. economy is poised for a recovery. Lower interest rates and the fiscal stimulus (roughly 25%) have started to filter through the economy.
And as history has proved time and again, betting against the U.S. consumer has proved to deteriminal every time the "death of the consumer" is pronounced.
Briefing.com is forecasting a 3% increase in third quarter GDP. That is, if the inventory adjustment does not interfere once again as it did in Q2. The fact remains consumer spending continues to trend higher and the full impact from the fiscal stimulus is far from over. Falling home prices and high gas prices have yet to stem consumer spending. And we don't see this trend changing.
Specific industries we like include media, general merchandise stores, casinos and gaming, department stores, and education services.
ArchiveThe global commodity complex is in a corrective mode that started with a break in crude oil prices. The supercycle was due for a correction and it's clear prices had reached a tipping point. The catalyst for the sell-off has been a mix of several factors, but mainly it's the renewed focus on slowing economic growth dampening demand. The "short the dollar, long commodities" trade is essentially over. Slower global economic growth is now taking the spotlight and fears of a global slowdown will continue to put downside pressure on commodity prices and related industries..
We have been long-term commodity bulls over the last few years, but in recent months we had become increasingly concerned over the dollar's influence on commodity prices. Crude was essentially trading as a dollar proxy. Factors outside supply/demand had taken hold of the crude markets like never before due to the sheer amount of speculative money in this market. As such, given the dollar premium built into all commodities, we feared real downside risk from a reversal of fortune in the greenback. From our vantage point, we saw a "prevalence in recent months of onesided views on many commodities, which has, in the past, forecast a near-term top." Now that the dollar has finally found its footing, coupled with increasing concerns over slowing global growth, commodities are correcting and it's likely only just beginning.
At this point, the demand side of the equation is also being clouded by the impact the Olympics are having on China's buying patterns of raw materials from metals to steel. It remains to be seen whether after the games if the buyers will step back in. For now, sentiment remains negative with the bears in full control.
Our underweight position reflects concerns over falling commodity prices over the next few months, a stronger dollar, and slower international growth. The combination of these factors likely results in underperformance. The sector rotation out of Materials and commodities has caused significant selling pressure in producers globally. We do, however, continue to hold positive views on several markets including coal, steel and aluminum where the markets are in deficit position due to secular changes taking place.
ArchiveThe Overweight rating in the Industrial sector reflects the international infrastructure build out taking place globally, as well as improving economic growth in the U.S. Economic growth, urbanization, industrialization, and rising purchasing power are fueling a massive global power infrastructure boom, which is why "The Global Power Play" ranks No. 1 of Briefing's Next Big Thing themes.
This upcycle has bifurcated globally into two distinct trends. Fast growth rates in the emerging markets have resulted in the rapid development, expansion and distribution of basic and reliable power generation. In the developed markets, countries are in need of a massive upgrade of their aging electrical infrastructure. Power, water, ports, airports, and beyond, building is consuming rising amounts of capital that is expected to amass to over $20 trillion over the next decade.
We think that while the Q2 came in below expectations, due entirely to an inventory devaluation, the third quarter outlook is quite good. The market now seems content with the Fed's neutral stance, which is the only valid position at this point in the economic cycle. If energy and industrial commodities continue to trend downward helping to anchor inflation concerns, which looks to already be taking place, this increases the odds substantially that the next move would be a rate cut.
Preferred industries include rails, construction & engineering, logistics, and construction equipment.
ArchiveThe Consumer Staples sector is the second best performing index to date -- behind Health Care -- having gained over 8%. The performance over the last 52-weeks is even more impressive, rising nearly 20%. And while the staples continue to offer defensive qualities and a safe haven appeal in this manic market environment, our Market Weight rating reflects this outperformance, full valuations and the reversal in the dollar.
Staples heavyweights like General Mills (GIS), Kellogg (K), and HJ Heinz (HNZ) have faced considerable challenges this year from declining consumer spending to ramping raw material costs. To date, producers have been able to pass through cost inflation through pricing gains. A 20x trailing earnings multiple reflects the group's performance as many industries suffer from a lack of pricing power.
Mutinationals have also benefitted from a weak dollar, strong export demand, and an expanding global footprint. Some of our favored names in this category include globally diversified producers with strong brand equity. These include Coca-Cola (KO), Pepsico (PEP), Wal-Mart (WMT), General Mills (GIS), Procter & Gamble (PG), and Avon Products (AVP). These companies continue to capitalize on enduring growth with the global economy, particularly the emerging markets where companies are experiencing rapid growth rates and market share gains.
But while global market share gains will continue, the greenback will no longer provide the tailwind it has over the last few years. Furthermore, staples stocks are traditionally less cyclical and generate steady earnings growth. And as the economy eventually improves, money is likely to flow out in favor of sectors more sensitive to the ebb and flow of the economic cycle.
ArchiveLooking across the Energy sector, the destruction is far reaching as plummeting oil and natural gas prices have severed stock prices in half in a just over a month's time. What concerns us is commentary coming out of Wall Street and the popular press suggesting now is the time to buy Energy companies given the attractive valuations. For one, energy stocks have always been relatively cheap given their cyclical status. Two, one can't value an energy stock until a new price deck has been reached.
We've been recommending investors reduce exposure to energy since the end of June on fears the dollar's turn and real demand destruction would end its run. This is exactly what has happened with dampening demand expectations, coupled with a resurgence in the dollar has taken crude below the $117 per barrel. What is unknown at this point, is where oil will stop. Our forecast over the last month have been for a range of $115-$125 per barrel. Crude is already at the lower end of that range and we think, given the dollar's gains, could push crude even lower.
The key for buying energy stocks is not the price level in oil, but the trend. As long as the trend is down, equities will continue to face downside pressure. The key is stabilization. Once the trend changes and a new deck is established, energy stocks can be more accurately valued. Market participants are sure to try to bet ahead of this stabilization, but it's a risky endeavor, particularly given the sheer mass of money coming out of Energy and into other sectors like Health Care.
We continue to recommend not to fight the trend. At this point whether the new price deck is $120, $100, or $80 per barrel is anyone's guess. As we've long argued, this trade had become so one-sided (long crude, short the dollar) that its going to take time to unwind. The X factor here is geopolitical events and supply stoppages (i.e. recent events in Georgia, Iran, Nigeria, pipeline disruptions et al). For now, however, the bears are in full control.
Archive Incredibly, despite its defensive appeal, the Telecom sector ranks only second behind Financials in terms of worst performers to date as a confluence of issues cloud stocks. The cumulative 22.4% YTD decline in the S&P Telecom Services sector has been driven by the major carriers (Qwest -45%, Sprint -30%, AT&T -24%, and Verizon -20%), all of which have suffered severe selling pressure on concerns over competition, lagging DSL growth (possible broadband reaching saturation?), profitability, regulatory environment concerns, and constricting balance sheets. We think these issues have obscured growth prospects, which coupled with attractive shareholder value and growing demand for bundled services (driving revenues and margins), is why we are raising Telecom to an Overweight ranking. We would also point out a rebounding dollar has heightened investor interest in domestic sectors/industries like Telecom and networking services.There are a lot of cross currents within the telecom sector that have led to some confusion and investor disenchantment. There is little doubt consumers are tightening their purse strings, reducing demand for carrier services. Cost savings has further magnified the trend toward land line disconnections as consumers switch from a fixed to an all wireless home environment. This trend will continue for the foreseeable future.
Competition remains a primary concern, as well. Some companies are clearly better positioned than others. Cable companies, which we continue to argue will lose out in the end given their technological disadvantage (copper wire vs. fiber for the final connection), have been ramping their a la carte service packages to the detriment of the incumbents. Cable market share gains (Comcast CMCSA, Time Warner Cable TWC, and Cablevision CVC) could be behind slowing DSL growth rates. Both AT&T and Verizon reported diminutive broadband net subscriber additions in the second quarter. The other possibility provides little relief -- namely the fact broadband is reaching saturation. Through 2004-2007, broadband growth rose 22% per annum. The rate is expected to slow to 5% annually through 2011, according to Goldman Sachs.
Finally, one of the greatest reasons behind investor disillusionment is the current and future regulatory environment. There are many issues in play from spectrum allocation, frequency coordination, net neutrality, telephone rates, and interference. Foremost of which is the broadband spectrum, which will see a major change this February when television broadcasting switches from analog to digital. Also, this fall the two big bell companies, along with other telecom players, are expected to ask the FCC to simplify and/or cut intercarrier compensation payments. There are significant issues at stake and in an election year with looming commissioner changes, there is a lot of uncertainty which makes market participants very nervous.
Quite a considerable list of headwinds, but from our vantage point, we think the downside risk has been priced in. As such, we rate the sector as Overweight based on attractive valuations, growing demand for data transmissions from consumer devices, coupled with long-term growth from the ongoing rollout of bundled fiber-based broadband service offerings. AT&T and Verizon continue to roll out respective fiber networks, U-Verse and FiOS, with great success, particularly in Verizon's case. The primary issue, however, is the fact the vast majority of consumers still do not have access to the fastest broadband options. Therefore, cable companies are winning by default.
This competitive advantage will be short-lived. Cable companies will be left with second rate networks unable to compete with fiber networks built for services not even offered yet. Consider this: we've seen some estimates that predict current offered FiOS services only consume some 10-15% of the total network capacity. And while some contend with Verizon's large capex plans, they fail to see the bigger picture. Verizon is building out a network for next generation services. Forget the triple play, Verizon will deliver any content at any time (the basis for The Next Big Thing premise - Telecom Convergence) -- that's a strategic competitive shift that continue to allude investors focused in the near-term. Verizon, offering a dividend of 5% and earnings growth of 11%, trades at 13.6x trailing earnings -- a 47% discount to the market multiple. AT&T's dividend is 5.2%, which compares to an average 3.4% for the entire utility sector, and trades at 10.5x. We'd be scaling into positions (eyeing VZ in the low $30 range, T in the mid $20s.). As for Sprint, the company is at a significant competitive disadvantage and will eventually be acquired. Potential buyers include Google (GOOG), Comcast (CMCSA), SK Telecom (SKM).
Archive
In August, we shifted our Market View to one of accumulation, arguing for more a cyclical vs. a defensive stance for investors for a greater than 12-month time horizon. We suggest a moderate sector rotation for long-term horizon investors that includes a less pessimistic view on the Financial sector. This weekend's rescue of the government-based GSEs, Fannie and Freddie Mac, reaffirms this view. The intervention should boost investor and consumer confidence, improve financial firm's liquidity, unlock the choke hold in the secondary mortgage market, stabilize the housing market, and reduce the systemic risk, and eliminate the potential for an enduring credit contraction in the housing market. All together, the historical intervention should help the U.S. economy and equity markets move ahead.
Until the rescue, the market had been doing a good job of compartmentalizing issues facing the financials. Specifically, those financials that are considered to be at risk -- Fannie, Freddie, and Lehman Bros -- continue to be punished, while the rest of the group has largely stabilized. This would not have been the case three to six months ago, when all financials were guilty until proven innocent. What has changed is that we've now had three or four quarters of earnings reports and data that have allowed the market sufficient time to assess which banks are relatively healthy and which ones are not.
Now, the bottom line is, through the actions of the Federal Reserve and the Treasury, it's clear they are committed to mending the Financial landscape. These actions have included aggressively cutting interest rates, providing ample liquidity to financial institutions, and rescuing Fannie and Freddie Mac from being consumed by mounting losses that they were clearly undercapitalized to handle. All together these actions should help to firm consumer and investor confidence. Fears of the unknown have been the main catalyst behind the Financial sector volatility. The latest measure will help to eliminate the unknown and normalize activity, which is crucial to turning around the U.S. housing market. This will take time. But the GSE plan, which is just a temporary solution, is structured in a way that should allow for enough time to pass for the housing market to have stabilized.
While the headlines are likely to focus on the long-term ramifications of the rescue plan including shareholder value destruction, along with inflation, a poor jobs market, strained consumer balance sheets, and a deepening housing market recession, we think much of this bad news is priced into market expectations. Thus investors with a long-term time horizon should be seeking out bargains in stocks which we see as attractively priced compared to other asset classes. This includes financials, for which we would focus on diversified banks, regional banks (excluding areas with greatest asset deterioration), and asset managers.
Over the long-run, however, there remain more questions than answers for the financials including how the regulatory environment will change and what will be the profit drivers for financial firms over the next 2 to 5 years as risk management decelerates earnings. This is particularly true for the investment banks for which the deleveraging over the last year will significantly reduce their earnings power. Goldman is likely to remain the standout in this regard, but the group's tarnished view is likely to take a while to wipe away brought on by the failure of Bear Stearns to the likely sale and/or breakup of Lehman Bros.
There is also another point to consider that is the potential for write-ups as when the credit markets start functioning normally -- meaning the buyers begin to step back in -- as demand rise so too will prices. What it all adds up to is that people are trying to gauge when will earnings growth resume? Market participants are trying to come to grips with who will make it and who will fail and when the financials will start to recover and fundamentals will come back into view. Equities are likely to move ahead of this realization. We suggest to be ahead rather than behind the curve. The risk horizon has now changed. The greater risk is not owning financials over the long run, than owning them.
ArchiveThe Technology sector, which had rebounded throughout July, has reversed on growing fears over consumer spending and global growth. The Philadelphia Semiconductor index has plummeted to new lows piloted by chip giant, Intel (INTC), as investors reduce tech exposure. It's clear within the semiconductor industry, that companies are becoming incrementally cautious about their 2H08 outlook.
Forecasted PC growth of 10%+ has been providing support for the technology sector as a whole as it heads into its seasonally strongest period of the year -- the back to school and the holiday selling seasons. However, the anticipated demand pickup has yet to materialize. This has pushed up inventories which has and will continue to pressure prices and profits. The companies with the greatest exposure upstream to consumer electronic products are at the greatest risk. Recent reports from Dell (DELL) and Corning (GLW) are prime examples of this trend.
A wave of downgrades and revisions has already begun and Q3 is looking more disconcerting as earnings season nears. Merrill Lynch recently cut its rating on Advanced Micro Devices (AMD) on expectations of weaker PC demand will pressure pricing, while UBS cut its PC growth forecast in half to a mere 4%. If demand fails to materialize box makers lower prices and the ripple effect is left through the entire food chain from the hardware makers to the component producers. Notebooks remains the only pocket of strength.
Inventories are on the rise and the book to bill continues to fall. This does not bode well for semi cap equipment companies. The SIA predicts worldwide semiconductor sales of 4.3% for the year revised down from its mid-year forecast of 7.7% growth. The industry association continues to predict PC sales of 13% this year and handset growth of 10%. These numbers remain higher than analysts predict.
The handset market is facing the same challenging economic climate. However, the picture looks better. Nokia (NOK) has came out and stated it will not participate in price wars, lowering its Q3 market share estimates. RF Micro Devices' (RFMD) recent guidance reaffirmation, a key component supplier to the handset makers, supports this view. Nokia is clearly willing to scarafice share for the sake of profits - a move we applaud in this enviornment. The key will be to keeping the pipeline lean and equally weighted in terms of pricing.
The Technology sector is typically driven by upgrade cycles and the development of new technologies. We think on the software side in terms of driving enterprise productivity an area companies continue to spend, the outlook remains positive. But without a major cycle driver, end market demand is solely driven by consumer adoption. And in this economic climate, consumers will continue to restrain spending.
Technology stocks are quite cyclical being highly interest rate sensitive, our Market Weight rating on Technology reflects our economic view for a cyclical upturn next year. A stronger dollar should provide some support. Our favorite subsectors are Software and IT Consulting and Services, Communications Infrastructure. Our least favorite is Hardware, Semis, and Semi Cap Equipment.
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