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Best Bets: Playing Defense in Stocks

If the stock market is the place you want your money, note that the experts sometimes give conflicting advice. Some say think big, others urge you to think small.

But nearly all will tell you it pays to stay a little defensive, especially after such a volatile year. That generally means keeping your portfolio diversified and playing different sectors of the market, so if one sector goes sour, the others can hopefully make up for the loss.

But wouldn’t it be nice if all your diversified bets were winners? Here are some suggestions from the Wall Street pros …

Living large-cap growth

Kick and run isn’t good soccer strategy, and it doesn’t usually work for investments either – unless the emphasis is large cap growth, which should continue to perform well, many experts agree.

“The large cap growth style is still going to do well. Overall, their valuations are still decent, and their leadership position is fairly recent and not overdone,” said Alan Gayle, senior investment strategist for Trusco Capital Management.

Robert Doll, BlackRock’s global chief investment officer of equities, favors large cap stocks with exposure to non-U.S. earnings, and says his picks haven’t changed significantly since the beginning of the year despite intervening months of volatility. His sector favorites include technology, health care, energy and industrials.

Gina Martin, equity strategist for Wachovia Capital Markets, says she too is sticking with themes that have worked well all year. Her list of favorites includes techs, particularly semiconductors, energy, materials and industrials. “I like health care for the long term, but am treading lightly as it is highly exposed to political risk in the upcoming presidential election year.”

Playing defense amid uncertainty

Generally, though, equity allocations benefit from a little “shift and sag” defense – to borrow another phrase from the soccer playbook. And that’s never been more true than today.

The U.S. economy is slowing, the housing and mortgage markets are in a correction and major stock indexes have hit a series of record highs, spurring concerns that prices may have outpaced fundamentals. Yet the fourth quarter generally brings a nice seasonal boost.

A.G. Edwards will maintain its overall asset allocation of 65 percent stocks, 30 percent bonds and 5 percent cash, after shifting 5% to stocks from bonds in March, says Stuart Freemen, chief equity strategist for the brokerage.

A typical A.G. Edwards growth and income equity portfolio would consist of 60 percent large cap at, 10 percent U.S. mid cap, 18 percent short-term bonds, 8 percent foreign and developed country stocks and 4 percent-5 percent cash, Freeman says.

BlackRock’s Doll says the equity market still looks rewarding.. “Maybe I would be lower equity over 2006 by a single percentage point and slightly higher cash,” he says.

But equity strategist Peter Boockvar of Millar Tabak & Co. feels that the U.S. economy is slowing dramatically and says investors should “sell into rallies, in most groups, and use pullbacks to buy stocks with commodity exposure.”

Trusco’s Gayle, says: “I’m not 180-degrees apart [from Boockvar.] There are opportunities in exposure to metals, grains and other commodities.” However, Lehman Brothers economist Ethan Harris expects commodities (oil, in particular) to remain roughly flat in the year ahead.

Space for small caps?

For Trusco, an all-equity portfolio would be 65 percent to 70 percent large cap, 25 percent to 30 percent mid cap, and 5 percent to 6 percent small cap. The small cap sector is half last year’s allocation of 10 percent to 12 percent.

A.G. Edwards’ allocation doesn’t include any small caps and is now without the 5 percent to 10 percent in emerging markets segment that was part of the mix at the beginning of the year, says Freeman.

But some expect small caps to resume delivering returns of 5 percent to 12 percent within the next three quarters.

Chuck Purcell, senior investment manager at Aberdeen Asset Management, formerly Nationwide Funds, says small caps are looking better for many reasons, including the Federal Reserve bias toward lowering interest rates and potential revival of merger and acquisition activity, which he expects will include a large number of smaller transactions.

Jason Hodell, managing partner of Plainview Capital, agrees. “If business fundamental conditions continue to be the way they are, we should see a return to historical norms in small cap.”

For safety though, Hodell is maintaining a somewhat defensive stance. “Plainview controls the equity risk it takes by being diversified across all the sectors, rooting out companies that have low debt loads, sustained track records of earnings, and core businesses that aren’t volatile.” he said.

Haven in technology

To that end, the technology sector fits nicely, he said, as those companies currently have little debt, top line growth that outpaces the general economy and low valuations.

He’s currently holding 31 percent of his portfolio in technology, up from a standard 20 percent. One sector he’s staying clear of is health care because of its potential volatility.

“Technology represents a rare combination of high growth stocks and business models that have been consistently profitable with increased profit margins,” Hodell says..

Regarding tech, Wachovia’s Martin says that although software and services should continue to see steady growth, semiconductors, which have significantly underperformed the market, are expected to enjoy a 20 percent increase in earnings next year, leaving them very cheaply valued looking based on forward earnings.

Finding value in financials

Because financials were beaten down so badly during the summer credit markets meltdown, many hold there are now opportunities for investors to find bargains among companies whose exposure to now-suspect loans and financial debt products wasn’t that great.

In fact, small cap financials is the only component of the Russell 2000 that is down in the last 12 months, says Craig Peckham, equity strategist for Jefferies & Co., who also notes that the Fed loosening as a positive. “Investors should not ignore the fact that the yield curve is as steep as it's been in almost two years – a positive for the financials,” he says.

Purcell switched to market weight from underweight on financials when the Fed lowered interest rates, and now he’s overweight, and particularly interested in opportunities in M&A-focused boutiques.

Richard Bove, securities strategist covering banks and brokers for Punk, Ziegel and Co., says financials are a mixed bag, and it might be premature to investing in them given ongoing concerns about the quality of loan portfolios. But he has a few favorite banks, including SunTrust Banksand Northern Trust.

Northern Trust is becoming a preferred bank among the very wealthy, who are disillusioned with new-style financial instruments and are looking to return to traditional money managers, Bove said.

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