AY: Monday Morning Musings: The Money Supply For New Equity Purchases (Part 1 of

07:17am EDT  1-Jul-02 Salomon Smith Barney Intl  (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: The Money Supply For New Equity Purchases

July 1, 2002              SUMMARY

* Foreigners are not the only possible buyers of U.S.

Tobias M. Levkovich       equities

* Domestic equity mutual fund flows show the bearish

          nature of investors

* Cash M&A activity also not providing a boost

* There are still high money market fund assets as a

% of equity values

 * Catalysts are needed such as EPS given the "show

me" attitude of investors

* ISM data suggests that production will rise further

and drive the EPS

  * A tactical summer rally is still quite plausible

OPINION

In the wake of accounting scandals, corporate governance issues and the weaker

dollar, there appears to be an endless debate as to if foreign investors will

leave the U.S. markets after having thrown money into U.S. equities over the

last few years (Figure 1).  Indeed, comments by well-known investors including

George Soros about likely further weakness in the dollar are not likely to help

either.

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

Source:  DRI and Salomon Smith Barney

This debate is not one of minor import in that overall new funds flows to buy

equities have slipped over the past year or two using various methodologies to

track such flows.  For example, AMG services has indicated that equity mutual

funds experienced $5.8 billion of outflows the week ended June 26, in sync with

a major sift in bearishness noted by the AAII survey, showing bears accounting

for 46% of respondents vs. less than 26% the week earlier.  Moreover, when we

look at the data from the Investment Company Institute (Figure 2) , we easily

can see a sharp drop in equity fund inflows over the past couple of years --

but things look better thus far this year.  Indeed, year-to-date (through May),

equity fund inflows are up 88% year over year (although we suspect that

outflows did occur in June).

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

Source:  ICI

Moreover, another source of potential cash to buy stocks might come from cash

mergers and acquisition activity, which theoretically puts cash in the hand of

equity holders who now have to re-deploy that cash into new stocks.  But, M&A

activity has dropped meaningfully and cash deals already were declining before

that. In fact, as seen in Figure 3, cash deals dropped from providing $100

billion of new funds (at its peak) that could have been put back into other

equities to only $10 billion more recently (on a quarterly basis).

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

Source:  Salomon Smith Barney

Fortunately, as Figure 4 indicates, dividend income (that could be used for re-

investment) also has climbed despite low dividend yields.  But, that income

might very well not be earmarked for new equity commitments in the current

environment.  As a reminder, this has been one of the worst second quarters in

decades for stock market returns (with a more than 10% decline in the Dow Jones

Industrial Average from the end of 1Q02 and a more than 14% drop in the S&P

500, not to mention the greater than 20% plunge in the Nasdaq Composite).

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

Source:  Salomon Smith Barney

Furthermore, we track money market assets in order to understand the potential

"firepower" on the sidelines, paying particular attention to retail assets as a

percent of the Wilshire 5000.  In this context, Figure 5 indicates that retail

money market fund assets, at more than $1 trillion, are still at levels

relative to the Wilshire 5000 well above the 7%-9% range seen prior to the

"bubble" period (which began in 1998).  Indeed, we calculate that a 20%-type

short-term rally (something we consider plausible) would get us back to a level

below 8%.  When we look at overall money market fund assets (including

institutional funds), we see the ratios at new record levels, but we caution

that much of the institutional monies may never flow into the stock market.

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

Source:  DRI, ICI and Salomon Smith Barney

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

Source:  DRI, ICI and Salomon Smith Barney

As a result, we do not think that there is a paucity of potential new equity

investment money availability, but, rather, investors need reasons to buy and

that is tough to do in a lousy tape.  Generally speaking, with the S&P 500 off

13.8% year to date and all of that decline occurring in the past quarter, plus

the corporate governance issues, this is not a market for the faint-hearted.

On the other hand, the glory only goes to the brave and when there is fear in

buying stocks (as demonstrated by the pervasive bearishness and money manager

job security concerns), it does seem like one of those times to buy stocks.

The markets have managed to weather some awful storms without breaking down

below the September 21 lows and we think the 2Q02 earnings reporting period

could be the driver.  In April 2000, the link between racing equity prices and

weakening fundamentals began to get re-established as New Economy optimism came

face to face with earnings reality (even if it simply meant missing "whisper"

numbers) and this continued through 2001.  Now, the downward price momentum is

similarly out of sync with improving fundamentals and many investors expect

further downward earnings guidance from companies.  Thus, making numbers and

the potential that there already are more realistic numbers embedded into 2H02

EPS expectations might be all that is needed to generate a new trading upturn

that could be more lasting than the two or three day rallies that have fizzled

throughout the year thus far.  While we concede that the market is trapped in a

trading range (as we have discussed in previous Trading Places reports), that

does not preclude a vigorous rally off recent lows as consumer spending

generally remains healthy, valuation is certainly more reasonable, earnings

could provide positive data points and investor sentiment is grim.  Add in the

sense that the summer is considered to be a period in which investors flock to

the beaches rather than the trading desks and we could get a nice surprise.

Indeed, betting on the obvious  (like "Never Fight The Fed") has not quite

worked, such that betting against the conventional thought (when catalysts

exist) might be the smarter alternative.

As economist Steve Wieting has pointed out (Figure 7), investors have become

very reactive to earnings news rather than the market being anticipatory as it

has in the past (by trending higher or lower before earnings shifted).  Indeed,

PC-related business weakness warnings from Intel, Dell and Hewlett Packard

Compaq should have been a clear indicator for the pre-announcements at AMD,

Apple and Micron, but the latter three names still sold off in a reactive

manner when they pre-announced negatively.  Thus, we are in the "show me"

stage.  Should the numbers bear out, as we think possible, stocks most likely

benefit in the near term.

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

Source: Salomon Smith Barney Economic & Market Analysis

As we have indicated many times since last August, industrial production

generates earnings gains, but we now have a lead indicator for production

gains.  As one can derive from Figure 8, when we look at the ISM new orders

index and subtract the data on ISM inventories, we can get a bead on production

direction.  Thus, given that inventories continue to be drawn down and new

orders continue to expand (as seen once again in the Chicago PMI data),

production is set to continue its gains and thus generate the required earnings

growth that should stimulate some positive stock price action.

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

Source:  DRI Salomon Smith Barney

In summary, the pre-announcements generally have been positive (outside of the

tech arena), the economic news is far from bad, the near term earnings outlook

is quite positive and the corporate governance issues are beginning to be

redressed with the NYSE guidelines, SEC orders, CEO resignations and the fact

that the accounting profession is likely to not buckle under any corporate

pressure in the future (given the demise of Arthur Andersen).  This does not

mean that we cannot be blindsided by another negative corporate accounting

scandal, but that any such events would be historical in nature rather than

forward looking, and, arguably, investors are buying stocks for the future, not

the past.

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