Experts say energy stocks
still have room to rise

NEW YORK » The resolution of the presidential race gave Wall Street a surprising boost, helping equities gain more than 8 percent over the last three weeks. Now, with the end of the year in sight, it's a good time to take stock of your portfolio's sector allocations.

Looking over the 10 broad sectors of the Standard & Poor's 1500 Supercomposite, Liz Ann Sonders, chief investment strategist at Charles Schwab, favors energy, health care and telecommunications, but is neutral on financials, technology, industrials and materials. She recommends underweight exposure to the consumer discretionary, consumer staples and utilities sectors.

Schwab remains bullish about the long-term fundamentals for energy, which has been the best-performing sector year-to-date by a wide margin. Sonders sees opportunities for higher returns in the biggest oil companies, as well as those that specialize in exploration and production. Regardless of short-term volatility, she thinks crude prices are likely to remain at above-average levels, buoyed by robust expansion in China.

"Energy has had tremendous performance this year, but it is nowhere near the performance that oil has seen," Sonders said. "If you look at the projections of the companies, and what they're based on, it's nowhere near where energy prices are now. Expectations are down, but there is no chance earnings are going to be down for energy companies in '05. This is something we want to continue to ride."

David Chalupnik, head of equities at U.S. Bancorp Asset Management, agrees there's still room for growth in energy stocks, especially in oil services. The Philadelphia Oil Service index has been on a steady upward trend for some time, and has yet to match the price peak it reached in the third quarter of 2000.

"The fundamentals for energy have never been better, and the price of oil services definitely has been higher," Chalupnik said. "China is growing strongly, so there is great demand for energy and not a lot of extra supply. We believe oil companies will open up their wallets worldwide ... and oil services will be the best way to play the energy situation."

The profile for utilities is different, however. Given the strong performance of the sector so far this year, most analysts recommend taking profits and going underweight. Sonders agrees, but suggests maintaining some exposure to electric utilities.

At the other end of the performance spectrum lies health care, the most beaten-down sector of the market. Problems with various drugs, concerns about thin pipelines and the possibility that new regulations may dent future profits have pressured the whole sector. While caution is certainly warranted when it comes to drug makers, it may be a good time to look at related industries such as health care distributors and facilities, as valuations for many of those stocks have sunk to attractive levels.

The telecommunications sector may also deserve a closer look. Sonders notes that this group can effectively be split into two categories -- the wired side, which includes the old-school Baby Bells, and wireless, which is where she sees the best opportunity for investors. While traditional wired services have been hobbled by regulatory burdens, the wireless industry has expanded, and likely has more room to grow.

With interest rates rising, most investors are taking a cautious approach to the financial sector, but the Federal Reserve's measured pace of tightening creates unusual circumstances, which warrant a neutral rather than negative view, according to Schwab. Rates remain low by historical standards, while a relatively steep yield curve has allowed finance companies to borrow at low rates and lend at higher rates. This may create a good climate for regional banks.

There's also good reason to take a neutral posture on technology stocks, as the pace of economic growth slows. Capital spending is improving, however, which should fuel decent performance over the near-term. If you're looking to invest in this sector, Sonders recommends a focus on data processing and outsourcing stocks.

Meanwhile, the parts of the market that depend on consumers are starting to show signs of wear. Rising energy costs, the waning stimulus of tax cuts and the slowing of the refinancing boom will likely pressure the consumer discretionary sector, as will higher interest rates. And while there will always be a market for household products, rising commodity prices are likely to pressure the cost of goods in the consumer staples sector as well. In the current climate, it may become difficult to pass much of this additional cost on to customers.

Analysts are generally upbeat about what lies ahead for the fourth quarter and 2005, particularly since the period from November to April is seasonally strong. Post-election momentum is another reason for good cheer, particularly following strong third-quarter earnings.

"This election was so close, it caused so much uncertainty, the policies between the two candidates were significantly different, so it wound up that a lot of investors sat on their hands and sat on cash," Chalupnik said.