SB: Monday Morning Musings:  Deciphering The Disconnects

02:09pm EDT  5-Jul-02 Salomon Smith Barney (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings:  Deciphering The Disconnects

July 5, 2002              SUMMARY

* Just as missing optimistic "whisper" numbers in

Tobias M. Levkovich         2000 began to re-align runaway equity prices and

market fundamentals, so too should 2H02 outlooks

                   given the gloomy assessments already held by

investors.

* Strategic issues like higher equity risk

premiums, overly sanguine long-term stock market

return expectations, the weakening U.S. dollar and

no more budget surpluses or peace dividends should

not preclude tactical trading rallies (which we

      deem as being plausible this summer)

* Longer-term sector leaders now may become the

strategic decision

* Old economy sectors could take the leadership

            role from the more "growthy" tech and health care

industries over the next year, in our view.

* Banks remain misunderstood as well

* Tactical rally could be helped by some

accounting/governance fixes being put in place,

with beaten up TMT stocks likely to participate in

any rally

OPINION

Code Cracking Or Extreme Sentiment Shifts?

When one looks at the market and the economy, there are some clear disconnects.

The equity market, via its downward price momentum, arguably is signaling

something much more dire than a profits recession, while economic data is

indicating recovery along with an earnings rebound.  Moreover, even those who

contend that valuations are excessive (especially when one can not trust the

operating earnings data due to various accounting irregularity reports), might

have to concede that a 17.5x multiple (excluding the tech sector) on fiscal

2002 EPS and 15x on 2003's projected numbers does not argue convincingly that

the S&P 500 is terribly over-valued anymore.  Nonetheless, we have been asked

if there is some "secret code" that needs to be deciphered in terms of reading

the market's tea leaves.

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

Source:  FactSet and Salomon Smith Barney

One could have asked that same question two and a half years ago when stock

prices were trading higher on a daily basis and fundamentals were less than

pristine.  Interest rates were headed higher in late 1999, valuations were

stratospheric and new metrics for corporate performance, such as eyeballs,

numbers of clicks, strategic alliances and (our personal favorite) acquisitions

that generated "accretive" revenues, took hold.  At the time, bulls justified

the stock market trends with the New Economy mantra, reminding the old guard

that at major technological/economic inflection points, one cannot be

constrained by traditional methodologies that are behind the times.  Given the

past two years, one would have argued that those "secret codes" issued by the

market might best be described by intelligence agencies as Soviet-style

misinformation.  Thus, questions about secret codes currently seem similarly

off the mark, especially in a period where the stock market is being incredibly

reactive to daily news and has lost its anticipatory capacity since March 2000.

To a certain degree, the downward price momentum was just a reaction to the

paucity of earnings relative to expectations and the extremes of a new investor

class (the individual) who mistakenly assumed that the sky was the limit and

there was no such thing as equity risk premiums.

The Glue That Binds Things Together

But, one has to go back to April 2000 to better understand how the market

began to get re-aligned with fundamentals and why it occurred in order to

comprehend the potential for a similar re-connection of business and market

trends now that they appear to be out of sync once again.  In April of 2000,

most companies actually met or topped projected First Call estimates, but, in

many instances, failed to clear the "whisper" projection hurdles of revenues,

earnings or cash flow.  In this context, the investment community had built in

expectations that were greater than the Street estimates and disappointment

reigned in the ensuing quarters as well.  In fact, that reactive behavior was

seen last Wednesday when SPX Corporation reiterated its 2Q02 earnings outlook

(in line with the First Call numbers) and the stock dropped as investors seemed

to think that an upside surprise was likely.  Thus, we can begin to comprehend

this notion of the gap between fundamental reality and market perception that

is not always easy to measure.

As we head into the quarterly results, we are encouraged by the relatively

positive pre-announcement season as well as by the lack of faith in any kind of

business upturn.  The media is full of stories of corporate malfeasance, no

imminent capital spending (specifically tech) turnaround, foreign investors

likely to flee in droves due to the weaker dollar, terrorism fears and the

assumed inability for the consumer to keep on spending.  The dearth of bulls is

palpable and the "death of equities" is being proclaimed from the ramparts.

Most investors already are assuming bad news in terms of 2H02 business outlooks

from management teams and they may not be disappointed entirely.  Besides, 2002

earnings estimates have been in a downward trend for the past six weeks (see

our bi-weekly "S&P Earnings Tracker" morning call notes).  Accordingly, in our

opinion, management guidance will be cautious and may even involve some further

trimming of forecasts (particularly in the technology, media and telecom

arena), but it might not be as dreadful as is already in the mindset of those

who perceive the economy through the very narrow scope of the tech sector

(which accounts for less than 4% of U.S. GDP).  The auto and related industries

account for more than 8% of GDP while the housing and related industries

comprise more than 4%, and both are doing quite well.  In simple terms, this

environment has got to be considered a contrarian's fantasy scenario and argues

for a vigorous rally this summer (in the midst of the supposed doldrums) that,

in our view, should encompass cyclical stocks (including beaten down technology

names).

The Strategic Vision Vs. A Tactical Trading Orientation

Yet, there is a critical issue that must be addressed and that is the

difference between tactical moves and strategic drivers when it comes to

equities.  And, while we have attempted to address this and delineate the two

in our "Trading Places" reports, it is important to revisit and better explain

the concepts.

Historically, after the U.S. equities markets experienced long bull markets,

such as the one witnessed in the 1950s through the mid-1960s, the next number

of years were not particularly rewarding as excesses needed to be wrung out of

the system -- thus, from 1966 to 1974 (Figure 2), investors lost money and

began to recoup losses over the next eight years (although the bear market

lasted through 1982 in real terms).  And, in many respects, a similar wringing

out is taking place currently.  Some of the issues involve expectations for

long-term EPS growth and, as a result, related stock market returns (which will

most likely be much lower going forward vs. the latter 1990s), the fact that

average Americas have put more money into equities (directly, or indirectly

through pension contributions) already, a return to budget deficits and the end

of the peace dividend, not to mention concerns about the end of disinflation.

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

Source:  Global Financial Database and Salomon Smith Barney

As one can see from Figure 3, individual investors have certainly jacked up the

proportion of their financial assets that now sit in stocks, but one should

also bear in mind that real estate holdings still dwarf stock holdings (Figure

4), so equities as a percent of total assets are not as high as they may seem.

Nonetheless, it is plausible that the equity culture of the 1990s is scaled

back somewhat and, at the margin, curbs the upside over the next few years.

Therefore, investor expectations for more than high single-digit returns (over

the next five years) from equities are just not realistic.  That does not

preclude individual stocks from generating robust gains, but those who think

15%-20% annual stock price appreciation is an entitlement are likely to be

profoundly disappointed.

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

Source:  DRI and Salomon Smith Barney

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

Source:  DRI and Salomon Smith Barney

Plus, a weakening dollar did not disrupt equity market appreciation from 1985

through 1989, despite U.S. record budget deficits in a seemingly successful bid

to bankrupt the Soviet Union via an arms race.  Moreover, the strong dollar of

the past two years has done little to stem the flow of red ink in most

portfolios.  Therefore, it is not as black and white as some would think,

although we agree that longer term equity returns cannot get back to the

aberrational 25%-plus gains of the second half of the 1990s.

As a result, we may have to think more in tactical (rather than strategic)

terms when it comes to the equity markets.  Moreover, when thinking tactically,

we need to look at shorter-term indicators like the earnings yield gap standard

deviations (Figure 5) and stock market volatility (Figure 6) as well as

sentiment surveys and mutual fund flows.  Using such criteria, we would argue

that buying stocks makes a fair amount of sense currently, given that stocks

relative to bonds seem very, very attractive near term.  Obviously, strategic

approaches are more important to money managers making decisions on vast

amounts of money, since short term trading moves may not be much of an option

for large asset allocators.

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

Source:  DRI, FactSet and Salomon Smith Barney

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

Source:  FactSet and Salomon Smith Barney

In our opinion, the challenge for those portfolio managers is identifying the

new leaders, which we think may be more of the Rust Belt types, with

industrials and materials leading the way (due partially to under-investment

over the past few years) along with the banking sector that has not been beaten

up by the TMT downturn, given that the bubble was primarily funded by equities

and high-yield debt and not bank debt.  Moreover, despite all the concerns

about debt and bankruptcy statistics, not to mention, corporate bond spreads,

U.S. corporations' ability to service their debt is much better today than it

was in 1990-91 (Figure 7).  Hence, we still like banks like Wells Fargo and

Bank of America, as well as Nucor and Louisiana Pacific, plus Deere & Company,

Pactiv, Borg Warner, Ford Motor and defense stocks such as Northrop Grumman.

On the other hand, from a strategic (rather than tactical perspective), the IT

sector still seems less attractive given over-investment and the lack of

secular trends that can sustain valuations.  And, we still consider it too

early to buy the drug stocks.

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

Corporate Governance Issue Might Be In The Eighth Inning

While there is deep concern about the sense of corporate rot amongst investors,

we would highlight that a number of remedies are well on their way to fixing

the issue including the SEC requirement for the principal executive and

financial officers to sign to the veracity of company numbers, the proposed New

York Stock Exchange guidelines that are very likely to be adopted within the

next few months and the recent public humiliation of executives who allegedly

have done wrong.  As reported recently by Challenger, Gray & Christmas, 197

CEOs either resigned or were pushed out in 2Q02, with the Wall Street Journal

reporting that 44 CEOs lost their jobs in the first 11 days of June alone.

Thus, the housecleaning has moved along in a fairly speedy way.  And, we

strongly doubt that any partner at a major accounting firm will give in to

corporate client pressure over a dispute and just sign off on the audit since

the demise of Arthur Andersen.

While many worry that such tactics are likely to slow earnings growth in view

of the inability to "play games" we would note that the NIPA data is showing

strong corporate earnings recovery already and we continue to believe that the

accounting irregularities found at some prominent companies do not reflect the

vast majority of U.S. entities.  Moreover, given the speed in which the fixes

are being put into place, the reported U.S. public company figures in the

future probably will be the most transparent they have ever been and should

dispel the sense of a new "disclosure discount" for U.S. equity multiples vs.

other regions around the world.  We also would highlight the fact that, even

after 12 years, Japan has not moved with the same sense of urgency as the U.S.

authorities have in addressing its structural problems.  Hence, we contend that

much of the bad news associated with governance and accounting credibility

should fall away soon, adding to the tactical rally effort.

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