Inside Wall Street: Playing Smart Defense in a Volatile Market

Defense is the best offense, according to some savvy strategists, as intense volatility continues to rock the market. Whether or not the equity market will snap back strongly like a coiled spring, as many bulls still predict, some major players have dug deeper into their protective shells by locking onto one or two stock sectors they believe will weather the bewildering storm.

At Standard & Poor's, for instance, market strategists recommend over-weighting your portfolio in just two groups -- information technology and consumer staples. S&P is now advising clients to steer clear of the financial, consumer discretionary, and materials (such as chemicals and mining) sectors. "Our current sector positioning reflects a defensive, counter-cyclical posture," says Alec Young, equity strategist at S&P.

Unquestionably, it will be an uphill battle for investors. "The S&P 500 reversed July's strong gains in August as downbeat macro-economic news on jobs, housing, and the consumer have offset the earnings euphoria, resulting in a volatile trading environment that's been exacerbated by low summer volume," says Young. He rates as "market weight" (or neutral) the energy, industrial, telecom services and utilities sectors.

The big fear factor is the question of whether the economic recovery is still on track. S&P economists are skeptical and have cut their 2010 U.S. real GDP forecasts to 2.8% from 3.1%, and it sees continued deceleration in 2011. Worries that the economic environment will continue to weaken are "diluting the positive impact of the budding M&A revival," says Young. Investors are troubled, he adds, by the large cash positions that are "burning a hole in corporate pockets, leading companies in the current M&A rush to potentially "overpay for assets in a deteriorating environment."

Two Stocks That Fit the Bill

In technology and consumer staples, S&P's top choices are International Business Machines (IBM) and Coca-Cola (KO). In this uncertain economic environment, S&P's emphasis has shifted to earnings consistency, product quality, and dependability based on growth and expansion. Those are among the basic reasons why "we are highly positive on IBM and Coca-Cola," he says.

IBM's global capabilities include information technology services, software, computer hardware, fundamental research, and related financing. Most investors already know IBM so it isn't exactly a new idea nor is it the most exciting stock story in technology. But in IBM, you get consistency, quality, and dependability all in one, says Young. In this fragile market environment, that's golden."The stock has withstood the market slide quite well. currently trading at around $124 a share, not too distant from its 52-week high of $133 reached in February.

Analyst Thomas W. Smith, who follows IBM at S&P, says the computer giant should benefit from the strong growth in the emerging markets, and the widening of margins. He expects gross margins to expand to 46.4% in 2010, up from 45.7% in 2009, as a result of continued cost reductions and improved sales mix.

He figures IBM is worth $161 a share based on his 2010 earnings estimate of $11.50 a share and $12.60 in 2011. Such strong earnings growth, enhanced by a dividend yield of 2.04% make the tech leader a compelling value, argues Smith.

Shares of Coca-Cola also has been a strong and steadfast performer, trading at $56 a share, close to its 52-week high of $59 -- in spite of the market turbulence. The world's largest soft-drink company still has a relatively attractive international footprint and the capability to generate strong free cash flow, says S&P analyst Esther Y. Kwon. She expects the stock to climb to $65 in 12 months. Coke's free cash flow, she believes, will be returned to shareholders through dividends and stock buybacks. Currently, Coke pays a dividend yield of 3.18%.

Fearing the Financials

Although positive on J.P. MorganChase (JPM), Bank of America (BAC), and Citigroup (C), S&P isn't as sanguine on the other financial stocks, and recommends reducing stakes in the group. One big reason: the sector has been a weak performer. Young notes that year- to-date through Aug. 24, the S&P Financials Index, which represents 15.8% of the S&P 500-stock index, declined 6.3%, vs. the S&P 500's drop of 5.7%. That compared poorly with last year's results of a 14.8% gain. Young worries that rising charge-offs on credit card loans and commercial mortgages due to higher unemployment will continue to pressure earnings. While the large diversified banks, such as J.P Morgan, Bank of America, and Citigroup are able to withstand such pressures, the smaller banks and financial companies aren't well positioned to do the same.

One stock in the sector that S&P rates a sell is SL Green Realty (SLG), a real estate investment trust that owns a portfolio of office properties in Manhattan. Its stock, which sped up from $34 a share in September 2009, to $66 in May, is now trading at $58. S&P analyst Royal F. Shepard, who expects the stock to weaken, has a 12-month target of $53, based on his 2010 earnings estimate of $4.05 a share, down from last year's $4.57.Shepard expects SL Green's total portfolio to experience a decline in occupancy of 90% in 2010. Last year, it dropped to about 93%.

In the consumer discretionary sector, a stock that's high on S&P's sell list is Sears Holdings (SHLD), one of the largest broadline retailers, with 2,297 locations in the U.S. Its stock has tumbled from $121 a share in April to $63 on Aug. 26. It traded as high as $160 in May 2009. :We perceive more downside risk for Sears given a slow housing recovery, and a lack of destination brands in fashion apparel and accessories," says S&P analyst Jason N. Asaeda. He has a 12-month target of $58 a share for Sears stock, based on his earnings estimate of $$2.50 a share for fiscal 2011 ending Jan. 31, down from fiscal 2010's $2.71.

In the materials sector, one stock in S&P's dump list is E.I du Pont de Nemours (DD), the second largest U.S. chemicals manufacturer, whose stock has performed well, trading at $40 a share, near its 52-week high of $43. But S&P analyst Richard O'Reilly expects the stock will likely stay flat, and sag to $38. One problem the analyst sees is the headwinds the company is facing from much lower profits from its pharmaceutical products beginning this year.

Strategists who are worried that the economic growth projections are weakening, amid slumping consumer spending aren't exactly throwing in the towel. After all, usually defies the majority thinking, which the bulls are counting on. So the market could turn without any advance warning. But the skeptics expect investors will continue to gravitate toward more defensive alternatives, as well attractive dividend yields. With the stock market's continued wild and erratic swings, who could blame them?