As chief investment strategist and a longtime member of Standard & Poor’s investment policy committee, Sam Stovall, a 14-year veteran at S&P, joins the IA asset allocation panel beginning with the March 2003 issue, replacing Arnold Kaufman, who is retiring. This month, Stovall explains the reasoning behind S&P’s recommended allocation of 65% stocks, 15% bonds, and 20% cash.

Can you tell us why S&P maintains a 65% stock allocation?

Our feeling is that stocks are more likely to offer the best growth potential over the coming years. Investors are asking, “Where do I put my money?” And our thought is that there is better opportunity in stocks than anywhere else. Let’s look at cash. In a money market fund you’re getting about half of the dividend yield on the S&P 500; that is not a lot. Even though you do get the safety of FDIC insurance, it is way less than 1%. After taxes and inflation, that number becomes negative. So we really didn’t feel that cash was a great investment, certainly we have money in cash to put to work later on, but we don’t have a lot. We don’t think that it is going to be a “Cash is King” situation for quite a while.

So then is your 20% cash holding appropriate?

We do have 20% because we feel that bonds have even less upside potential than equities. With yields being at a 40-year low, we feel that, at best, yields could drift from here. Depending if you are dealing with intermediate- or short-term bonds, that drift is anywhere from 2% to 4%. Again that is not very much, but the likelihood of losing money has been increased, especially with the stimulus package that is working its way through Congress. The projections for improving the economy, and the fact that we are at 40-year lows, means there is greater risk than reward potential. And that leaves us with stocks. You don’t want to get too aggressive with stock allocations because we are in a gyrating market with an awful lot of near-term worries; but a market that is still fairly richly valued when you look at P/Es. I guess the thought is that there aren’t many exciting alternatives to what’s out there. So you can go with what our longer-term projections are, and stocks look the best with maybe 7% to 8% returns over the next couple of years.

What are your sector expectations?

We are focusing on sectors that do particularly well when coming out of a recession, typically economically sensitive areas like some of the consumer discretionaries, energy, and materials. Those are considered long-term investments.

Near-term, however, due to the nervousness of the marketplace, we think consumer staples such as food, beverage, household products, and personal care products are likely to do well. In these products, the demand is fairly static, they are focused in what they offer, and they don’t engage in a lot of crazy acquisitions. Their earnings are not only very predictable, but they are also fairly transparent. So we don’t have a lot of companies that are under any skeptical areas.

Do you believe then that we are coming out of the current recession?

Yes, that is our feeling. In our opinion the recession ended in 2001. In 2002 we saw four quarters worth of growth, about 2.4% on a real GDP basis, and we are looking for about 3% growth this year. We are also looking for positive numbers in both consumer spending and business spending. Additionally, our earnings outlook is optimistic. On a bottoms-up operating basis, we are looking for a 15% to 17% increase for the S&P 500.

How would a war affect the U.S. economy?

I don’t see the war lasting for a long period of time. And I don’t see energy prices rising over $50 a barrel and staying there for several months–which is what we think is needed to slow economic growth. The Iraq situation is certainly a wild card and a source of uncertainty, but we don’t see it lasting beyond the first quarter or the early part of the second quarter.