AY: Monday Morning Musings: Are Stocks Cheap Enough Yet?

07:37am EDT 10-Jun-02 Salomon Smith Barney Intl  (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: Are Stocks Cheap Enough Yet?

June 10, 2002             SUMMARY

* Stocks do seem to be getting attractive again on

Tobias M. Levkovich         earnings yield gap analysis basis

* Earnings should get a substantive boost as

   production moves higher and allows for better fixed

(capital equipment) cost absorption

* Our more cyclical sector weightings posture should

pan out

      * The IT sector may be able to generate a bounce as

well

* Dollar woes should not restrain an earnings-driven

rebound

OPINION

(*) An immediate family member of Tobias Levkovich holds a long position in the

securities of Intel.

Given the recent beating taken by the stock market, with the S&P 500 down 10.5%

year to date (after losses in 2000 and 2001) and the Nasdaq Composite off 21.3%

this year, the question of valuation does come up once or twice.  While we hear

and read that stocks are overvalued relative to historical P/E ratios (either

average P/Es or prior market troughs in 1987 or 1974), we would point out that

the average inflation rate in the past 30 years has been 5.1% and the rate of

inflation was 11% in 1974 and 3.6% in 1987.  Currently, expected inflation as

measured by the spread between 10-year Treasury notes nominal yields and

inflation-indexed yields of similar maturity (Figure 1) is only 2% and thus the

real value of assets should be worth more (hence, the valuation adjustment).

Figure 1:  (Figures can be seen in PDF format)

Source:   DRI and Salomon Smith Barney

Moreover, as we have demonstrated on previous occasions, lower inflation also

has provided for better corporate margins vs. misguided perceptions that low

inflation collapses pricing power and thereby margins.

Figure 2:  (Figures can be seen in PDF format)

Source:   DRI  and Salomon Smith Barney

EYG Work Suggesting A Bottom Could Be Forming

As a result, we tend to think that one has to look at an earnings yield gap

type analysis to determine attractive relative valuation (stocks vs. bonds),

which has signaled previous market bottoms.  Specifically, if we look at the

S&P 500 earnings yield gap (the inverted P/E less bond yields) on forward EPS

estimates, we can see that we are just about two standard deviations below the

five-year mean (see Figure 3), a level that has been a useful guide to buy

stocks.  The September 21, 2002, bottom unleashed a major rally and we could be

near a similar rallying point especially if earnings recover as we think is

very plausible given higher industrial production trends.  Bear in mind that in

view of higher ISM new orders, production almost has to follow higher, which

should propel EPS upwards.

Figure 3:  (Figures can be seen in PDF format)

Source:   DRI, FactSet and Salomon Smith Barney

The question that we constantly face is why?  As Figure 4 illustrates,

Corporate America's Capital Consumption Allowance (or essentially depreciation

charges against fixed plant and equipment assets) has just about doubled in the

past 10 years to $1.4 trillion.  Thus, a 5% decline in industrial production,

for example, would translate into a $70 billion operating profits shortfall as

companies would not be able to spread these fixed charges against a similar

amount of units produced, thereby driving up the per unit overhead cost.

Interestingly, when we go back to 2000, we can see that industrial production

has declined more than 6%, which translates into about $85 billion of corporate

profits simply disappearing.  Since, we just as easily understand that a

production recovery causes the positive swing (irrespective of the impact of

stock options or pension income), we feel confident about an earnings rebound

that can last through 2002 and into 2003 unless there is an exogenous shock to

final demand.  Additionally, we would refer back to the pre-announcement trends

we mentioned in our last Monday Morning Musings in which we pointed out that

the negative pre-announcement warnings vs. positive pre-announcements ratio has

waned markedly from 4.3x in 1Q01 to 1.2x in 2Q02 (according to FirstCall data).

This suggests that Street estimates are getting much more in line with actual

trends and the earnings disappointment issue is fading rapidly, although Intel

did jar the market.

Figure 4:  (Figures can be seen in PDF format)

Source:   DRI and Salomon Smith Barney

Note that the service sector is heavily influenced by production trends and the

recent ISM data is encouraging on the service sector also, which tends to have

meaningful fixed costs as well.  For example, transportation services have

meaningful physical assets (like trucks and aircraft) that carry hefty capital

costs and dramatic capital investment in Information Technology since 1997 also

has to be depreciated by the financial services and telecom sectors, for

instance.  Indeed, we strongly doubt that most investors are even aware that

the Nasdaq Transportation Index is up more than 8% year to date, way

outperforming the Composite's 21% loss.

We have shown on numerous occasions that earnings are directly impacted by

production trends and as production has started to rebound of late it should

come as no surprise that 2Q02 EPS estimates are forecast to be up more than 7%

year over year.  We also would point out that stock prices have a very close

correlation to earnings as Figure 5 below clearly shows.

Figure 5:  (Figures can be seen in PDF format)

Source:   FactSet and Salomon Smith Barney

While some investors prattle on about possible deal overhang given a rising

backlog at equity capital market syndicate desks, rising backlogs from 1992-98

(Figure 6) did little to stem the market run and we are wary of suggestions

that it should now.

Figure 6:  (Figures can be seen in PDF format)

Source:   SDC, FactSet and Salomon Smith Barney

How To Position Oneself For A Rally

While it is always difficult to pinpoint when rallies begin, we would note that

we are very close to the point where earnings should turn more meaningfully and

that valuations seem to be in line with previous bottoms.  Thus, it looks like

another leg of the recovery story is coming into place.  Valuation is seemingly

more attractive, investor sentiment is horrendous, earnings should be climbing

and many of the geopolitical concerns have not blown up into the full-scale

global crises that we have feared.  Moreover, the constant focus on market

momentum (currently in a downtrend) could shift in fairly abrupt volatile ways

causing severe short covering.  In this context, we would prefer not to be on

the wrong side of that trade   Furthermore, since we consider this to be a more

cyclical event, we remind investors where are our sector weights are and some

of our more favored groups (Figure 7).  In addition, we think that given the

appearance of near term capitulation in anything IT-related, we might see a

positive trading opportunity in the tech arena emerge and spread across the

semiconductor space into capital spending sensitive areas like storage, network

equipment, software and even some hardware.  Fundamentally, this means that

corporate enterprise spending rebounds, not telecom services' capex recovery

due to the unique nature of the debt burden being carried by telecom service

providers.  Thus, while short covering could benefit names like JDS Uniphase,

Lucent and Nortel Networks, demand drivers for their products are still very

limited.  We always have heard that the time to buy the market is when no one

else wants to.  Given that we now seem to have an armageddon mentality (vs.

"the sky's the limit" attitude of two and a half years ago), we are buyers.

Figure 7:  (Figures can be seen in PDF format)

Source: Salomon Smith Barney

Can The Dollar Disrupt The Party Plans?

Investors do seem overly concerned that a weak dollar will clobber stocks as

foreign investors either invest at home or pull out from U.S. equities.  At the

margin, this is possible, but the fundamental realities of a weaker dollar are

higher domestic earnings (due to more local currency translation of foreign

sales and earnings or a newfound more competitive global advantage to win

additional business).  At the same time, a lower dollar risks higher interest

rates as a result of imported inflation concerns and the need to attract

foreign buyers to fund the budget surplus with more attractive rates

(especially as Canada, Australia and possibly the UK lift rates).  As a

reminder, foreign investors own $3.4 trillion of U.S. credit instruments (or

bonds) of which half are U.S. government securities vs. $1.6 trillion of U.S.

equities that should benefit as earnings prospects improve.  Clearly a strong

dollar over the past two years has done nothing to support stock prices as

earnings fell, and thus, as earnings strengthen, it is far from obvious that

stocks will falter going forward simply because of any dollar weakness.

Inflation would push up rates and threaten consumer spending as well as the

housing market, but real estate generally has been considered an inflation

hedge, so collapsing home prices is far from assured.  Needless to say,

inflation would have a negative impact on bonds.  Admittedly higher rates would

compress P/E multiples, but at least there is an earnings offset; bonds, on the

other hand, seem to be a very poor investor choice if dollar weakness causes

possible inflation and capital flight.  Accordingly, the earnings yield gap

work does support the argument that stocks are cheap again relative to bonds.

(*) An immediate family member of Tobias Levkovich holds a long position in the

securities of Intel.