AY: Monday Morning Musings:  Sticking To Our Guns

08:15am EDT 24-Jun-02 Salomon Smith Barney Intl  (Tobias M. Levkovich

Institutional Equity Strategy

Monday Morning Musings:  Sticking To Our Guns

June 24, 2002             SUMMARY

* Staying with the bullish posture in the face of

Tobias M. Levkovich       momentum selling

* Investors seem to want a successful bottom test or

capitulation

             * There has been good news on earnings which has

largely been ignored

* Earnings yield gap valuation metrics still

indicating a buy signal

    * A weaker dollar still seems more of a threat to

bonds

* Unfortunately, dividend yield support is lacking

as a buffer to any exogenous "shocks"

OPINION

Not Crying "Wolf" or "Uncle"

The U.S. equity markets have continued their decline, with last week being

another down leg despite an attempted rally on Monday.  In many respects, the

investment community seems to be waiting for a successful retest of the

September 2001 lows or some sort of "cataclysmic crescendo of capitulation"

such as the one experienced the week of September 17, 2001, before wading back

into stocks.  Seemingly, we either have to see a violent purging of stocks from

investor portfolios (vs. the current "water torture" expunging) or the

technical requisite bottom test.  Yet, as one can see from Figure 1 below, the

October 1974 bear market low was never retested, although we came quite close

to another low in December 1974.  Thus, even market bears might need to

conclude that such retests are not always necessary, but still possible.

Moreover, skeptics would readily admit that powerful bear market rallies are

quite plausible, particularly when one sees extremes in negative investor

sentiment and oversold market conditions in the face of improving economic and

earnings news.

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

Source:  Global Financial Database and Salomon Smith Barney

It is in that context that we are sticking to our guns and maintaining our

tactically bullish view given the trading environment that we began

highlighting last December.  To be fair, we did not forecast the market's

retreat since mid-March 2002, as the news of corporate malfeasance spread

(beyond Enron and a limited number of other companies), not to mention the

flare up on the Kashmir border.  Moreover, the incredibly reactive nature of

the market to daily news over the past two years also indicates that there is

no anticipatory discounting of earnings recovery in stocks today as we thought

would emerge - something that has been the case in past downturns and

recoveries.  Indeed, following warnings from Intel and weak business conditions

commentary from IBM and Hewlett Packard Compaq, most investors should not have

been that surprised by the pre-announcements from Apple Computer or Advanced

Micro Devices, but the reactive behavior was quite evident.  In addition, the

dismal telecom services industry capital spending environment for the likes of

Lucent, Nortel, JDS Uniphase or Ciena is quite far from being a new revelation

unless one has been hiding out on a desert island for the past six-to-twelve

months.  But, for every Amdocs earnings disappointment, there has been an

Arvin-Meritor upside EPS pre-announcement.  For every Merck, there has been a

Maytag, for every CMS Energy, a KB Homes and for every Lucent, a Lear

Corporation.  It simply is not all bad news, despite the headline-grabbing

attention given to the former technology and health care leaders.  Market

transitions are always bumpy, but this bout of turbulence has been far choppier

than many can remember.  The positive pre-announcements are almost equal to the

negative ones, and earnings should get even better in 2H02 as industrial

production rises year over year.  This earnings rebound, combined with our

sense that investor sentiment has become universally bearish (except for maybe

the sell-side strategists who do not control much money anyway) is causing us

to hold back from knuckling under the downward price momentum pressures.

Hence, we are unwilling to cry "uncle."

Building Character

The key reason that we are unwilling to bend under the market trading pressures

is that fundamentals appear generally good, including higher M2 money supply

once again, a reasonably improving earnings outlook, attractive valuation (on

an earnings yield gap basis), and the aforementioned grim investor sentiment.

Moreover, we believe investors continue to misunderstand the impact of a weaker

dollar.  Note that while most investors in the U.S. are very aware of the fact

that that many U.S., market indices are within spitting distance of the

September 21, 2002 lows, they are probably less conscious of the fact that

European equity markets are also hovering around nine-month lows despite the

Euro's strength vs. the dollar of late.  Plus, Japan's Nikkei index is up only

3.5% year-to-date (but down in local currency) as a result of the dollar

weakness relative to the Yen.  Thus, it may be difficult to argue successfully

that investors have shifted their funds to overseas markets across the board.

To be sure, the South African market has been strong, mainly due to its

resource-based economy in the aftermath of a gold price surge.  And higher

energy prices since late last year have bolstered the Russian markets, while

domestic consumption recovery has bolstered the Indonesian and Korean markets.

Nevertheless, global equity market returns overall have been disappointing.

As one can see in Figures 2 and 3, since the end of 1997 (pre-bubble), foreign

investors have added about $770 billion to their U.S. equity holdings while

boosting their bond assets by $1.8 trillion over the same time period.  In very

simple terms, a weaker dollar is inflationary as U.S. buyers will have to dish

out additional dollars for the same imports (of toys, shoes, apparel,

semiconductors, etc.).  In addition, wars tend to be inflationary.  Thus, there

may be some upward pressure on interest rates over time.  But, the bigger issue

is the ballooning U.S. budget deficit which still needs to be financed.  Thus,

foreign investors most likely will need to be compensated for taking on added

currency risk by demanding (and receiving) higher long term rates.

Accordingly, we remain concerned that so called "defensive" bond allocations

seem quite offensive.

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

Source:  DRI and Salomon Smith Barney

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

Source:  DRI and Salomon Smith Barney

Furthermore, while some investors seem to want to position their portfolios for

a weaker dollar, we would be careful in looking at overseas sales exposure

alone for making investment decisions.  For instance, Colgate Palmolive

generates a very meaningful amount of its profits from Latin America and

Brazilian economic concerns could overwhelm the aggregate benefits of overall

currency translation.

While we pointed out last week that the earnings yield gap using a forward P/E

basis was signaling that stocks should outperform bonds handily, Figure 4

highlights that such valuation metrics are beginning to show a similar pattern

when we use trailing P/E data as well.  Hence, it seems unlikely that further

stock price pullbacks are possible.

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

Source:  DRI, FactSet and Salomon Smith Barney

What Could Go Wrong?

Given the weakness of the equity markets, we have asked ourselves what might

the market be telling us?   Louise Yamada, SSB's technical analyst, continues

to warn us of a secular bear trend, while there is no shortage of geopolitical

concerns, including news of an audio tape yesterday alleging that Osama Bin

Laden is still alive and planning new attacks against America and Jews.

Moreover, the border between Israel and Lebanon (and thereby Syria) flared up

on Sunday with Hizbullah anti-aircraft fire hitting Israeli towns, leading one

Israeli commander to comment about an "inevitable confrontation."  Thus,

watching for breakdowns below the September 21 lows could admittedly cause us

some significant pause.

Our greatest concerns have been for major oil shocks (that would disrupt the

consumer sector) or meaningful increases in terrorism (which would undermine

confidence).  Most polls show that Americans have assumed that there will be

additional terrorism, but it is hard to determine how people respond to any new

attacks.

To be sure, we are not seeing much in terms of dividend support for the market

either, with an S&P 500 dividend yield just north of 1.5% (and an earnings

payout ratio of slightly more than 35%) compared with a 3.5% yield back in the

market trough of 1990 (when the payout ratio was more like 42%).

Fascinatingly, the Financials sector yields are above 2.0% and not far from the

1990 levels (Figure 5), while the Information Technology sector has almost no

yield support (Figure 6) and the traditionally high yielding Utilities sector

is well below its historical base, but still remains quite healthy (Figure 7).

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

Source:  FactSet and Salomon Smith Barney

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

Source:  FactSet and Salomon Smith Barney

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

Source:  FactSet and Salomon Smith Barney

In this context, we do not believe that we are acting in a "perma-bull" manner,

despite repeated advice to buy stocks in the last three months and having

started 2001 with a definitively cautious posture only to get more aggressive

in April 2001 and to pull back in late May.  Moreover, we scaled back our

interest in the equity markets late last November and jumped back on the equity

bandwagon on February 19, 2002.  Consequently, we contend that we are not

crying "wolf" when we suggest buying equities currently.  Our sense is that

investors are giving up on stocks, with domestic equity funds experiencing cash

outflows for the past four weeks, which seems reasonable given the typical

nature of retail investors lagging following the direction of equities.

Volatility indices are also quite high (Figure 8).  Indeed, even the small cap

rally seems to have fizzled in the wake of higher valuation than large cap

names, a weaker dollar (which benefits larger multinationals) and 60% relative

outperformance over the past two years.  Therefore, there does not seem to be

much hope built into equities anymore -- what else can one ask for?

Figure 8:  (Figures can be seen in PDF format)

Source:  FactSet and Salomon Smith Barney

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