10:30am EDT 15-Jul-02 Salomon Smith Barney Intl  (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: Is The Market's Winter Thawing Out?

July 15, 2002             SUMMARY

* Signs are emerging that the stock market may be

Tobias M. Levkovich       "warming up"

* Nasdaq outperformance of late is one such

positive sign; our proprietary sentiment indicator

is signaling buy as well

* Tech is not outrageously valued in our view, and

macro environment is sound despite disappointing

              consumer confidence numbers Friday

* After ending, bull markets do not typically

transition quickly into new bull phases, although

powerful trading rallies  - when tactical

approaches become important - are not uncommon

* Tech may prove to be a leader in these trading

rallies although we continue to be wary of tech

                  from a longer term strategic perspective

* Our "Trading Places III" report will be available

on Tuesday

* Severely beaten up stocks are likely to benefit

                          from a trading rally, including a number of tech,

telecom, financial, discretionary, and industrial

names

OPINION

Note: All referenced figures can be found in the PDF version of this document,

which is available on FC Linx and GEO.

Maybe it is the Canadian roots of this writer, but the market's chilling

performance over the past sixteen weeks reminds us of those long freezing

winter months (November, December, January and February) that can be so cold

that they can be debilitating.  No one wants to venture out, with frostbite (or

worse) being the high price to be paid for going about normal business.  In

many respects, the investment community has been through its version of a

nor'easter, with buying stocks being very costly (as one highly-respected

market watcher expressed it to us -- like "catching razors").  But, there are

signs of a thaw as summer finally kicks in.

In the last few days, we have noticed a number of notable changes.  In

particular, we have witnessed the Nasdaq Composite outperform the S&P 500 and

the Dow Jones Industrial Average.  Given that the Nasdaq was the leading

decliner off the bubble's peak (down a shocking 73% for those who need

capitulation confirmation) and has experienced a major pullback in valuation

(Figure 1).

Figure 1

Source: Factset

Figure 2:

Source: Factset

While not cheap, by most standards, it is no longer outrageously valued either

(given cyclically weak earning) and we retain our suspicions that projected

earnings for 2003 are aggressive.  Nonetheless, this below the radar screen

shift is intriguing for us given our view that the tech sector still had

problems to work through.  Bear in mind that the Information Technology sector

now accounts for about 14% of the S&P 500's market capitalization weight

(Figure 3), down from a peak of almost 35% in March 2000 (and it comprised

slightly more than 12% in 1995).  Thus, one can pretty fairly argue that the

bubble totally has dissipated with expectations now in the dumpster.

Figure 3

Source: Factset

We would be very careful in making assumptions that technology can be the same

leader it was previously, but we are excited about its potential to spark the

summer rally since, for better or for worse, this is still the group that

people want to talk about the most and thus has a hold on the market that

cannot be shaken as quickly as we would like.  Accordingly, though we hate to

admit it, we do believe that tech will be the bear market rally's leader, not

the next bull market's driver.  As SSB Global Equities Market Strategist

Matthew Merritt has pointed out several times recently, bull markets do not go

through bear market phases and immediately bounce back into another bull market

trend.  And, as we have highlighted in our "Trading Places" series, which we

started last December (our "Trading Places III" report should be out on

Tuesday) major market corrections generally mean that new market leaderships

needs to be found to propel the next bull market and the old leaders do not

resurface.  But, that does not mean that we cannot get a vigorous bounce off

the significant declines we have experienced.

Indeed, as one can see from Figure 4, this is exactly how investors made money

from 1966 through 1982, although to be fair, the market bottomed in 1974 and

investors doubled their money (in nominal terms) over the next eight years.

Accordingly, while the Strategic (and thereby longer term) issues in the U.S.

markets are far from resolved (such as the weaker dollar, the end of the

public's insatiable desire to own stocks, valuation, disinflation, earnings

quality, definitive growth drivers, the impact of hedge funds, etc.), one has

to be vigilant to take advantage of Tactical (shorter term) trading

opportunities.  And, while we share many of the strategic concerns, we feel

that one has to be watching for trading rallies and we think one is emerging in

the summer thaw.  Indeed, tools like our Earnings Yield Gap analysis and The

Other PE model, helps us determine timing for more nimble stock market

tacticians, since missing out on 20%-25% bear market rallies almost ensures

underperformance.  As we noted last week, investors' attitudes have shifted

from a Return ON Capital to a Return OF Capital, which argues that some

significant level of market submission has occurred already, but not in one

"cataclysmic crescendo of capitulation" that many have been looking for, but

rather via a multitude of mini stock-specific capitulations.

Figure 4

Source: SSB

Why Believe In Tech Leading A Summer Comeback?

Aside from the market signals we seem to be picking up and the valuation chart

shown above, Figure 5 highlights a number of recent factors that we think is

signaling a change.  Some of these items are psychological (which is critical

for shifting sentiment) and some are fundamentally based (which satisfies our

criteria).

Figure 5

Source: Salomon Smith Barney Institutional Equity Strategy

Most recently, Jonathan Joseph has noted some pickup in DRAM prices, which has

been one of the first things to slip in April (and thereby cause some of the

carnage in the SOX) as well as initial indications of better motherboard

shipments (another interesting precursor).  Dell's earnings news was also very

encouraging (as seen in Friday's market trading). In addition, some tech stocks

with strong cash positions are showing stock price resilience (or support, in

technician terms).  Warren Buffet's investment in Level Three, while not

overwhelming to us, did provide some market participants with a sense of a

price floor in the battered telecom services sector as well.  Plus, reports of

talks between AT&T Wireless and Voicestream also suggested the notion of

telecom industry consolidation that many have been looking for.

The economy, in general, does not seem to be rolling over despite the ongoing

concerns about double dips.  Retail sales looked generally fine for June (after

May's pause) and industrial production (a key earnings driver in our view) is

rising, while housing remains robust given low long-term interest rates and

there has not been a slowdown in eating out (based on restaurant data).  To be

sure, the Consumer Confidence numbers were very disappointing, but they reflect

the attitude of people with negative influences such as the corporate

malfeasance stories, the related weak stock market and terrorism concerns

rather than a spike in unemployment and a collapse of earnings that would

easily translate into renewed economic weakness.  Keep in mind that consumer

credit rose in June unexpectedly and that simply does not jive with a weakening

of spending intentions, especially if one looks at the Redbook data for early

July.  Hence, the macro environment does not seem threatening, in our opinion.

What To Buy?

In a trading rally, it is quite likely that some of the most beaten up names

bounce due in part to short covering and possibly related to so-called bargain

hunting.  In this context, we could see crushed tech stocks as well as drug and

biotech names bounce sharply.  In addition, financials, consumer discretionary

and industrials may participate as capital market woes caused cyclical fears

that began hitting those names too of late.  Thus, Pfizer and Amgen may pop

alongside Intel and AOL Time Warner, not to mention Deere and Lockheed Martin.

We should stress that we are not changing our generally negative view of the

Health Care sector but we acknowledge its short-term bounce potential.  We

would prefer to buy the pounded managed care names like Aetna, where valuation

shave come down substantially despite very strong pricing trends going into

2003.

But, in order to be a little more quantitative in our approach, we decided to

run some beta studies and found once again that two of the highest beta sectors

are technology and financials, while traditional defensive areas like health

care and consumer staples are not.  Nonetheless, we provide a list of those

names that have meaningful beta to the market (Figure 6).  The screen was run

using the S&P 500 and S&P 1500 Supercomposite and the results were revealing.

For instance, electronic contract manufacturers showed up, as did some

semiconductor and semi equipment manufacturers.  Fascinatingly, the only

financial name to jump out in the Top 25 Beta list was Stillwell Financial, for

some obvious reasons.  Admittedly, we were a bit surprised that names like

Cisco, Sun Microsystems, Dell, Applied Materials and EMC did not show up, but

we did a cut-off of just the Top 25 names so as not to overwhelm our readers.

Keep in mind that Figure 7 provides the Top 10 anti-rally list; those few

corporate souls that run counter to the market.  Utility stocks are very

evident in this list but names like Hershey Foods and AmerisourceBergen

Corporation are notable.

Figure 6

Source: SSB and Factset

Figure 7

Source: SSB and Factset

In our opinion, the market seems poised to gain this summer and investors

appear overly fearful due to corporate scandals, terrorism fears and a whole

host of exogenous factors that ignore the market's inherent fundamentals.

Indeed, a recent Financial Times poll of strategists and economists found that

most of these professionals now expect a down year in equities for 2002 (Figure

8), indicating that most are bearish despite what many perceive as overly

aggressive allocations to equities.

Figure 8

Source: Financial Times Deutschland, July 12, 2001

Plus, as we look out 12 months, we will be in that generally positive third

year of the presidential cycle when the stock market has never been down since

World War II (including the 1987 crash, see Figure 9).  Thus, if one has a time

horizon beyond the next minute and a realization that investors already have

dumped stocks to the tune of that 74% decline in the Nadsaq, some relief should

be on the way, with a thawing out being likely.  We recognize that there is

further downward risk as the weak markets potentially impinged on economic

trends.  Nonetheless, the reward seems to be outweighing the risk.

Figure 9

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The information contained herein, including any expression of opinion, has been obtained from, or is based upon, sources believed by us to be reliable, but is not guaranteed as to accuracy or completeness. This is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell, the securities or commodities, if any, referred to herein. There is risk of loss in all trading.