Standard & Poor’s Equity Strategy has changed two sector recommendations and now advises a marketweight position in the utilities sector, previously underweight, and an underweight position in the materials sector, previously marketweight. While we expect favorable profit comparisons for the utilities sector in 2007, aided by rate increases and the strength of wholesale power markets, we believe the current valuation of the sector adequately reflects these favorable trends. At the same time, S&P recommends investors take advantage of the current M&A euphoria surrounding Alcoa by reducing their exposure to the materials group.
Regarding the utilities sector, profit growth should help offset the high pension-related costs many companies in this sector face. In addition, the sector’s 3.1% dividend yield is attractive in light of the low 15% tax rate on corporate dividends (which has been extended through 2010). Lastly, the technical outlook for the utilities sector is increasingly positive relative to the current overbought nature of many other sectors.
S&P advises a 3.5% weighting to the utility sector.
S&P analysts project decelerating profit growth in 2007 for the materials sector; a 27% advance in operating earnings in 2006 is expected to shrink to only a 6% rise in 2007. This projected slowdown can be attributed to slower worldwide consumption growth and increased production; a cyclical peak, or at least a plateau, in prices for many base metals; and a lack of further cost benefit from reduced feedstock costs. In addition, the group has recently experienced eroding technicals.