AY: Monday Morning Musings: To Negativity and Beyond

08:37am EDT 17-Jun-02 Salomon Smith Barney Intl (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: To Negativity and Beyond ...

June 17, 2002 SUMMARY

* Profits ARE beginning to recover, in our view.

Tobias M. Levkovich * Capital spending CAN climb in periods of low

capacity utilization

* Industrial production news should outweigh the

volatile consumer sentiment news

* Our "LEVIS" index is getting better with

liquidity and sentiment also kicking in now

* The investment environment is not as bad as some

would like us to believe

OPINION

Over the weekend, we saw reports that the "doyens of the double dip" have

backed off their very pessimistic views and now concede that Mr. Greenspan's

"pedestrian" recovery is the more likely outcome. In addition, some have

charged that the past three years of S&P 500 earnings have been due to

"accounting slight of hand" rather than underlying business trends, which we

would argue is not that great a revelation when looking at the NIPA margin data

vs. S&P 400 (Industrials) margins. Indeed, if the mirage of 1999-2000 earnings

argument were true, and that our peak earnings base was more like 1997-98, we

are well on our way to earnings recovery off the 2001 trough (Figure 1) and

such news should be cheered.

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

Source: DRI and SSB

Negativism Abounds

Fascinatingly, we still see reports about the fact that given capacity

utilization of only 75.5%, we will not and cannot see capital spending recovery

that will drive production (and, thereby employment) higher. Seemingly,

everyone has forgotten history again since capital spending began rebounding in

late 1975 (after the severe 1973-74 recession) with capacity utilization at a

mere 76% (Figure 2) and again in 1983 (following the 1979-82 slump) at just 74%

utilization levels. The issue at hand is never capacity levels, but the most

efficient (profit-producing) capacity. If that were not the case, the

semiconductor industry (which started 2002 with capacity utilization of about

62% globally) would not be pouring in tens of billions of dollars into 300mm

wafer fabs that can drive down the cost of a chip by 30%. To be blunt, in our

view, such arguments suggesting no capital investment recovery given low

capacity utilization are simply untrue and seem like attempts to rewrite

history in revisionist terms.

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

Source: DRI and SSB

To be fair, the latest University of Michigan consumer sentiment data was a

"downer," but most probably reflected concerns over terrorism (following the

Vice President's and FBI Director's respective warnings last month), reports of

corporate malfeasance and the weakened stock market, rather than added job

losses or higher interest rates. Indeed, recent Gallup polls have shown

growing discomfort amongst the citizenry, as many Americans seem worried that

initial U.S. military successes against terrorism have waned.

The fact that industrial production has jumped for five months straight cannot

and should not be ignored given its consistent impact on earnings. Indeed,

should industrial production (IP) remain flat at current levels (Figure 3), it

will turn positive year over year by September and that would argue for

meaningfully higher 2H02 EPS (against easy comparisons last year) as IP has

been a 30-plus year consistent driver for earnings. Yet, given auto companies'

announcements of higher North American build rates, production most likely will

move even higher than Figure 3 suggests.

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

Source: DRI and SSB

As we have been telling clients for months and Economist Steven Wieting

recounts in his recent write-up ("Will The Short Run Spoil The Long Run?"), the

market has not been anticipatory for two years now. It has been entirely

reactive and thus should react positively to better earnings news once it comes

out. Even though we know that things are improving, investors seemingly want

very clear proof, but they continue to be restrained by the earnings shortfalls

of the likes of Sprint and Lucent. Unfortunately, weakness in the telecom

services and telecom equipment spending sensitive areas should not be much of a

surprise to anyone who has picked up a business periodical in the last few

months. Plus, capital spending related weakness at IBM and others is similarly

not surprising in that capex lags earnings recovery by about two quarters.

Long Hair and Levis

Many years ago, we were told about buying stocks with "hair" on them,

intimating that the stories were not that "clean" and thus one was buying the

stocks at a discount with the expectation that the hair would get trimmed. In

many respects, the overall market now has hair on it, given stock options,

pension income, one-time write-offs, corporate governance concerns, terrorism,

the U.S. dollar, etc., but all of that makes us want to buy the "discount."

Investors have pulled money out of equity funds for the past two weeks, based

on AMG data, while the Volatility Index (VIX) is hovering around 30 and, at one

point in time, the put/call ratio got to 145% on Friday morning (during the

major swoon at the open). In a certain respect, we are seeing investors give

up but not in the grand scale of a "cataclysmic crescendo of capitulation" that

everyone seems to want (as experienced in October 1987). As a reminder, no one

rings a bell at the bottom! In addition, as opposed to what we saw occurring

in mid-December 2001, M2 money supply has begun to edge back up.

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

Source: DRI and SSB

In fact when we look at our "LEVIS" index, we find Liquidity improving over the

past few weeks, Earnings looking ready to turn (with better-than-average

negative-to-positive pre-announcement trends), Valuation much better (given the

forward earnings yield gap being two standard deviations below its five-year

mean) and Investor Sentiment having fallen sharply (as measured by recent

polls, the VIX and the recent two week exit from stock funds). Thus, with a

good LEVIS fit, every instinct tells us that this is the time to buy

(tactically) within the broader framework of a trading market.

Interpreting Everything As Being Bad

In the past few weeks, we have watched many investors choose to look at the

world through "blue"-colored glasses, appraising the data with uniformly

negative assessments. An alleged housing bubble will erode as mortgage rates

climb, but lower interest rates recently (as can be determined when looking at

10-year Treasury notes) should assist mortgage rates and refinancing activity;

this is ignored. The chances that the Fed may wait until much later this year

to raise short term rates is similarly deemed unworthy of our interest. Anemic

job growth (versus job losses) is seen as proof that things cannot get better,

but the Manpower hiring intentions survey suggest that more jobs will open up

in 3Q02. Even the weak May retail sales data could be confounded by better

early indicators for June.

While some telecom equipment vendors, including Nokia, were downbeat, the

positive surprise was the more upbeat news out of Motorola. But, we are in a

period where any news is not seen as good even if it is. When Intel warned of

its earnings miss, most investors overlooked a more positive report from

National Semiconductor, and all chip names were hurt. Similarly, good earnings

news out of Maytag and various auto component suppliers must have been

considered irrelevant, although the market did reward Proctor & Gamble.

Even those who have liked small cap stocks wonder if that opportunity might

have peaked and thus the overall equity market is doomed. However, at the same

time, they seem to pay no heed to the fact that mega cap stocks (the ones who

have greater weight in the market index) have experienced a major pullback in

valuation (Figure 5) such that they trade at a slight discount to the market

today. Hence, they could begin to lead us out of the morass again. In many

cases, these companies do not need new equity funding (including names like

General Electric, IBM and Phillip Morris) and should be able to appreciate in a

rising market. In this context, all is far from lost, but it sure does not

feel that way when talking with investors who are as grim as we have ever seen

them.

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

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