News Analysis
BusinessWeek.com
August 10, 2006
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The Post-Pause Portfolio

Though the Fed took a break from interest-rate hikes, its future moves are unclear. Investors may want to check out these strategies

Now what? On Aug. 8, the Federal Reserve finally gave Wall Street a long-awaited pause from interest-rate hikes, but so far, the markets haven't known what to make of it (see BusinessWeek.com, 8/8/06, "The Pause that Perplexes"). Did the Fed hike one too many times, endangering growth? Is it being foolhardy in the face of rising inflation? Either way, investors can take a few steps to protect their portfolios, as experts debate the meaning of the Fed's latest move.

One thing, at least, is certain: The interest-rate outlook is still uncertain. Some economists, including Jan Hatzius of Goldman Sachs (GS ), argue that the Fed is done tightening and will begin to cut interest rates early next year. Meanwhile, Bear Stearns (BSC ) economists and others maintain that the pause is just that: a pause. Another rate hike, they say, could come as early as October.

Even if the pause proves lasting, investors probably shouldn't break out the champagne quite yet. More often than not, market-watchers say, major indexes tend to decline in the six to eight months between the end of a tightening cycle and the arrival of rate cuts. "We think pauses are overrated," says David Rosenberg, North American economist at Merrill Lynch (MER ) in an Aug. 8 report.

While economists debate the topic, the rest of us have to decide what to do, if anything, about our investments. This week's Five for the Money looks at five strategies investors can use to keep their portfolios afloat in the current post-pause environment.

1. Stay defensive.
If uncertainty is what the market likes least, expect plenty of glum faces on Wall Street. With serious question marks still hovering over economic growth and inflation expectations, few asset classes stand poised for significant gains, some analysts say, so investors should remain cautious. "The era of muted returns is likely to continue," notes Richard Bernstein, Merrill's chief investment strategist, in another Aug. 8 dispatch.

The Fed maintained in its latest policy statement that inflation pressures will probably die down (see BusinessWeek.com, 8/8/06, "The Fed Shows Its Dovish Side"). However, policymakers could be wrong, so investors will be awaiting fresh inflation readings Aug. 15 and 16 for confirmation, according to Alec Young, equity market strategist at Standard & Poor's (MHP ). "We would continue to stay with our defensive outlook," Young says. "There are enough headwinds out there to keep [stocks] in a choppy [trading] range."

Meanwhile, the U.S. economy is cooling, according to the Fed and most economists. It's unclear how this slowdown will be felt in corporate earnings, but it seems likely that the S&P 500's unprecedented 17-quarter streak of double-digit earnings growth will eventually grind to a halt. "There's going to be much more of a focus on earnings," says Brian Gendreau, investment strategist at ING Investment Management (ING ).

2. Get an energy boost.
One group that shouldn't lose much steam is the energy sector. Big oil producers like Exxon Mobil (XOM ) and Chevron (CVX ) were posting big gains before the Fed pause, and there's no reason for that to change amid ongoing Mideast tensions and the recent Prudhoe Bay pipeline closure, analysts say (see BusinessWeek.com, 7/17/06, "The Bunker Portfolio"). September West Texas Intermediate crude oil futures settled at $76.35 on Aug. 9, after flirting with $77 and all-time closing highs.

Surging oil prices aside, some energy stocks actually look cheap from a valuation point of view, according to David Chalupnik, head of equities at First American Funds. He points particularly to Exxon and Apache (APA ). "For a lot of these companies, oil would have to move down to $45 a barrel for them to be fairly valued today," Chalupnik says.

Exchange-traded funds, or ETFs, that invest in energy companies can provide simple, inexpensive exposure to the sector. For the year through afternoon trading Aug. 9, State Street Global Advisors' Energy Select Sector SPDR (XLE ) was up 16.8%, adjusting for dividends. This fund seeks to track the performance of the energy sector of the S&P 500 index and carries a low 0.25% expense ratio. Still, investors should bear in mind that this sector is volatile and could be risky.

3. Take a dose of health care.
As oil prices swing up and down, investors might want to consider a more traditional defensive play: the health-care sector. On July 31, Wachovia Securities upgraded health-care stocks from neutral to overweight, citing positive technical factors and historically cheap valuation. This sector "should insulate investors from oil's vicissitudes," adds Jack Ablin, chief investment officer at Harris Bank (BMO ).

In fact, health-care stocks have seen a sudden shift in their fortunes after languishing the first few months of the year. The Health Care Select Sector SPDR (XLV ), which tracks the S&P 500 health-care sector index, gained 5.2% in July despite flattish performance overall year-to-date.

Eric Barden, co-portfolio-manager of Texas Capital Growth & Value Fund (TCVGX ), especially likes the managed-care industry, including Coventry Healthcare (CVH ) and UnitedHealth Group (UNH ). "Their stock prices are typically dependent on whether these companies can raise premiums faster than medical costs are going up," Barden says. "With the exception of the Aetna (AET ) stumble earlier this quarter, most have demonstrated an ability to keep their pricing ahead of their costs."

4. Put some money in bank stocks.
As the economy slows, the financial sector tends to outperform the rest of the market. Some analysts expect the same to occur following this Fed pause, as a projected rally in government bonds causes the value of banks' bond portfolios to swell. The Philadelphia Banking Sector Index (BKX ) was up 6.2% for the year as of afternoon trading Aug. 9.

Those gains have come despite worries over a global uptrend in interest rates and a flattened yield curve, where there is little difference between long- and short-term rates. Financial stocks' performance has been helped in part by share-repurchase programs funded by the corporate bond market, according to Brian Reynolds, chief market strategist at M.S. Howells & Co. "If the banks can break out, then they will likely drag the rest of the stock market up with them," Reynolds says.

The Vanguard Financials ETF (VFH) offers exposure to roughly 540 stocks in the sector for a modest 0.26% expense ratio. Launched in 2004, the fund has posted one-year returns of 11.9%, compared to 5.38% for the S&P 500. A larger financials ETF, Financial Select SPDR (XLF ), has a longer track record but is limited to holdings from the S&P 500.

< strong>5. Use discretion with consumer names.
When the economy is slow, consumers usually buy only what they really need, such as food and clothing. Market-watchers are relatively mixed on companies that provide these consumer staples, but they're sounding a consistent note on sellers of consumer discretionary, or nonessential, items. At least in the near term, that message is: Avoid them.

Previous economic slowdowns don't bode well for the consumer discretionary sector, which includes companies such as Home Depot (HD ) and Disney (DIS). During the 10 periods since 1980 when the Institute for Supply Management's index of manufacturing activity has slowed, consumer discretionaries outperformed the S&P 500 only once, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup (C ).

The cooling housing market may be another bad option for discretionary buying (see BusinessWeek.com, 8/4/06, "A Damper Housing Market"). An estimated $81 billion was cashed out of home equity through first-lien refinancing during the second quarter, according to Freddie Mac (FRE ), up from $74 billion in the first quarter. "As house-price appreciation continues to slow, this mechanism for sustaining consumer spending will diminish," says S&P Equity Research.

In fact, technology and consumer discretionary are the only two sectors down so far this year, according to Henry McVey, chief U.S. investment strategist at Morgan Stanley (MS ). "If you had merely stayed out of these two sectors, you would have made money" in the market, he notes.

Of course, that knowledge might have been more useful for investors seven months ago. While no one has a crystal ball as to what Fed policymakers will do next, following a few cautious investment strategies may help portfolios weather the market's post-pause uncertainty.