U.S. Stock Market Sectors with the Best Prospects in the Year Ahead

The healthcare sector currently has the best attributes for an overweight position, largely due to prospects for future growth in earnings and free cash flow. Also, these are typically more immune to a slowdown in economic growth than is the case in other sectors. For pharmaceuticals, biotechnology, and the medical equipment makers, the bright outlook for strong profit growth helps offset the high P/E ratio with a more attractive PEG ratio. Furthermore, the payout ratio in healthcare is on a solid up-trend, which, when combined with strong growth of free cash flow, produces a good relative valuation.

The consumer staples sector also merits an overweight recommendation, helped in part by its "defensive" nature. The companies in this sector often show consistent earnings growth over the course of business cycles from selling relatively "inelastic" products and services. Typically, this feature is reflected in lower measures of stock price volatility and lower but steadier growth rates of earnings. The increasing exposure of this sector to global markets for new demand should bring benefits, with the three-year forecast showing profit growth of 4.8%, which is two times higher then the historical average in this sector. Although stock prices in this sector rose sharply in 2007, the dividend yield remains above its historical average.

The industrial sector's healthy forward profit growth and a relatively low P/E ratio lead to one of the lowest PEG ratios when compared to other sectors. Within industrials, Global Insight favors sectors that benefit from the weak U.S. dollar, such as agriculture equipment, aircraft, and machinery. In addition, oil and gas field machinery and farm equipment also benefit from high capital spending in the farm and energy sectors. The positive view on Industrials is also supported by strong readings in the sector's technical momentum indicator.

At the same time, a slowing economy will hurt some parts of industrials, particularly those related to industrial equipment. Several segments within the industrials sector that will be vulnerable are the automotive industry and related supply chains, construction, and construction machinery.

The information technology sector has an equal-weight recommendation. The IT sector outperformed other sectors in 2007, led by semiconductors, hardware, and networking, but it was lagging the market in early 2008. For this year, Global Insight expects good prospects for computers, as well as the systems software segments. Investment growth in information processing equipment is expected to slow to 5.8% in 2008 and 4.0% in 2009, but is still historically strong, particularly compared with the big declines in 2001 and 2002, after the Y2K scare. In addition, industry consolidation continues, as large companies acquire smaller ones to broaden their product offerings.

Also, many software companies have strong balance sheets with significant amounts of cash. On the negative side, the dividend yield and P/E ratios in IT are relatively unattractive relative to the other sectors, mostly due to a stock price jump in 2007, but they are still appealing when compared to their own history. To sum up, good prospects for future profits growth and free cash flow, along with negative readings on valuations and technical indicators, provide the basis for the equal weight recommendation.

The energy sector merits an underweight on the basis of relative valuation metrics and expectations of slowing future profits, which should be hit by narrower margins and softening demand due to a global slowdown. The forecast for oil prices shows a peak followed by a decline. As a result, energy has one of the strongest forward profit growth expectations among all sectors for 2008 and one of the weakest ones for 2009. In addition, dividend payouts in the United States have not kept up with growth in profits during the past few years. This has lowered the dividend payout ratio. Finally, many portions of the energy sector are committed to large-scale projects and big capital investments in coming years, which will slow the growth of future free cash flow.

The financial sector should continue to be hurt by weakness in housing and credit markets, write-downs of assets, high energy prices, and an economic recession. The prospects for returns from investing in the real estate segment remain very poor, with an underweight setting indicated by both the fundamental and risk indicators. The fallout from declining real estate sales will also continue to affect areas of the financial sector, such as investment funds exposed to the financial credit, banks, and other mortgage-related institutions that have large exposure to the real estate markets, as well as real estate brokers and developers themselves. At some point during 2008, it is expected that greater stability will be achieved, thus improving the outlook for this sector—but not yet.

To see the full sector rankings and for further information visit: www.globalinsight.com/SectorRotation.