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A Wall Street suspense story as told by an expert

This U.S. advisory visits the top strategist at Standard & Poor’s to see what plot twists the market will take — and which stocks look good.

We know that Charles Dickens visited Wall Street (as well as the Bowery and the notorious Five Points slum) on his trip to New York in 1842.

That may not seem strictly relevant to today’s markets, except that Mr. Sam Stovall, who calls himself a “stock market storyteller,” thinks Dickens’ Tale of Two Cities best describes the outlook for the market in 2008. It will be a tale of two halves.

Mr. Stovall is chief investment strategist at Standard & Poor’s. On behalf of Louis Rukeyser’s Wall Street, Mr. Benjamin Shepherd visited Mr. Stovall to get his reading on a market that is not that easy to read. That reading includes the stocks this strategist likes in the months ahead.

Mr. Stovall, who heads a crew of 65 equity analysts, claims there is little he can teach the group, many of whom have been covering their companies and industries for over 10 years.

Instead, he functions as a storyteller or stock market historian. He offers long-term guidance on such issues as “how does the market perform during a recession? Does it typically anticipate a recession? If so, for how long? How much does it typically decline in advance of a recession?”

Then there is the most basic of questions: Which sectors hold up and which “get creamed.”

Bargains too good to pass up

The first chapter of Mr. Stovall’s tale of two halves will be one of challenge and difficulty. In the second, things will return to normal. “I think that we’re actually going to be seeing the market probably log a bear market of between 20% and 25% before things turn around,” he says.

Technically, that’s less than the average bear market, he notes. Since the end of World War II, there have been 10 bear markets with an average decline of 32 per cent. So this one looks relatively mild. And there’s a reason for that, adds this strategist. He believes that stock valuations are quite attractive.

Does this mean, the advisory asked, that things will get down to levels where the bargains are too good to pass up?

“Yeah, I think so,” is Mr. Stovall’s reply. “Because when you’re looking at trailing earnings, nobody can claim that you’re being too optimistic about the future.” Trailing earnings, of course, are past earnings rather than projected earnings. They are the real deal, not educated guesses.

With Wall Street trading at about 15 times trailing earnings, the market is at a 20 per cent discount to the average price/earnings ratio for the past 20 years. That discount could reach 25 per cent.

How the tough get going

So if we’re looking at a 20 to 25 per cent decline, what areas of the market look attractive?

“There’s an old saying,” relates Mr. Stovall, “that when the going gets tough, the tough go eating, smoking and drinking — and then, if they overdo it, they go to the doctor.” In short, it’s the defensive areas (and behaviours) that people revert to that are attractive for investors.

Consumer staples are number one on the Standard & Poor’s list right now. The favoured stocks are Altria Group (NYSE-MO), parent company of Philip Morris (from which it recently spun off Philip Morris International), Procter & Gamble (NYSE-PG) and Coca-Cola (NYSE-KO).

But there’s another, less obvious pick: cosmetics firm Estee Lauder (NYSE-EL). Skincare doesn’t go by the board during a recession, either. The company must work out a tangled situation with department stores, but it has primed itself for future growth, says the strategist.

Utilities are another defensive favourite, right? Not so much, says Mr. Stovall. Their valuations are a bit stretched right now, in his opinion. But there are two exceptions: ONEOK (NYSE-OKE), a natural gas distributor, and Entergy (NYSE-ETR), which operates nuclear power plants.

Health care is the other area that Standard & Poor’s likes. “Some of the biotech has actually held up really well,” says Mr. Stovall. He likes three in particular. Psychiatric Solutions (NASDQ-PSYS) is the largest operator of psychiatric inpatient facilities in the U.S. Genzyme (NYSE-GENZ) specializes in the treatment of serious and rare diseases.

The third is Jerusalem-based Teva Pharmaceuticals (NASDQ-TEVA), a maker of generic drugs. Mr. Stovall likes the stock’s valuation, but he also likes its political possibilities. “It’s basically a generic pharmaceutical that will likely do well in an election year in which a lot of the rhetoric has to do with controlling healthcare costs.”

Republican meltdowns

Speaking of elections, the second half of the year will bring a turning of the political page in the U.S. Mr. Stovall has the normal Wall Street jitters about the possibility of a Democratic triumph and its impact on tax cuts (not so many) and health care (much higher spending). But once again he offers his historical perspective.

The fact is, he says, “that the market actually does better under a Democrat than under a Republican.” Since World War II, the market has advanced a little less under a Democrat than a Republican (71 vs. 75 per cent), but two mega-meltdowns — in the mid-1970s and earlier this decade — happened on the Republican watch. Thus the overall average favours the Democrats by a considerable margin.

For this first half of the divided year, Mr. Stovall has two more groups of stocks he doesn’t like. First are the much-maligned financial stocks, maligned for good reason in the strategist’s view. There’s just too much uncertainty. Technology stocks keep getting beat up by the market as well. “I wonder how much longer they can be the whipping boys of the investors unless earnings estimates are expected to plunge dramatically.”

Asked for one final observation for the next 12 months, this strategist comes up with one that would surprise many commentators: Don’t fight the Fed. When the Federal Reserve Board cuts interest rates, it has history on its side, says Mr. Stovall. The past 12 times the Fed started cutting rates, the market rose 11 of them by an average of 19 per cent.

So as far as this investment strategist is concerned, the story gets better as time goes by. If this actually were A Tale of Two Cities, the hero would lose his head. But there’s no need for investors to lose theirs if they pack their portfolios with a few solid bargains and calmly await a happier ending.