SB: Monday Morning Musings: The Equity Risk Premium At A 20-Year High

05:21pm EST  1-Nov-02 Salomon Smith Barney

Stock ratings are relative to analyst's industry coverage universe

Institutional Equity Strategy

Monday Morning Musings: The Equity Risk Premium At A 20-Year High

November 1, 2002          SUMMARY

* Investors are discounting an awful lot of bad news

Tobias M. Levkovich         already (and are pricing in less than 6% EPS growth)

* Equity risk premiums for telcos and utilities, in

particular, have soared

* Tech stock price strength seems unfounded and we

would be scaling out at current levels

* Financial stocks still seem pretty attractive yo

us, especially given a tripling in short interest

ratios for diversified financials

                   * Financials have decent betas without the risk

profile of tech

* Yet, bear in mind that Sentiment (the "S" of our

PULSE framework) has improved markedly -- our Other

PE index is out of panic mode as of late last week

OPINION

All referenced figures can only be seen in the PDF version of this document

available on GEO and FC Linx

One of the most difficult concepts in investment analytics to truly pin down is

the equity risk premium (ERP), since it is defined as the requisite differential

demanded by equity investors to own stocks vs. bonds.  In many ways, this

powerful notion is highly challenging to measure since it basically requires one

to take the pulse of all market participants in order to determine what the

level is and then to pick up on the continuous changes in positions.  As a

result, most investors have to look at "observed" ERP levels using historical

contexts.  In this respect, we have used 5.0% nominal EPS growth since that was

roughly the level achieved over the past 100 years.  And, as can be seen in

Figure 1 below, given current bond and dividend yields, the ERP seems to be

hovering at its 1979--like point.

Figure 1: N.B. Non posso allegare le immagini. Accontentatevi del resto. :)

Source:  Federal Reserve, FactSet and Salomon Smith Barney

Note that, in 1979, the price of oil soared as the Shah of Iran was deposed,

thereby exacerbating inflationary pressures, Americans were being held hostage

by militant students in Tehran, undermining U.S. power, domestic interest rates

were in the teens and the USSR invaded Afghanistan.  Given that backdrop, it is

no wonder that the ERP jumped.  And, while one might argue that global

geopolitical conditions are unsettled today and that the economic outlook is not

all that positive, it would seem that the equity markets have priced in a fair

degree of risk already.  Indeed, as indicated in Figure 2, the market is

implying a less than 6% growth rate for stocks when looking at historical

average ERPs.

Figure 2:

Source:  Federal Reserve, FactSet and Salomon Smith Barney

Are Stocks Or Bonds More Risky Now?

Moreover, when considering equity risk, one also has to think about bond risk

and we find the Market Vane survey on Treasury bonds to be a helpful signal.

Figure 3 illustrates that bond bullishness is declining but remains well above

its average reading of 55% and meaningfully above its 40% level when previous

equity market rallies have fizzled.  Plus, nearly $15.9 billion of net new cash

flowed into bond funds during September, according to the Investment Company

Institute, while $16.1 billion exited equity funds, highlighting individual

investors' preferences regarding equity risk.

Figure 3:

Source:  Bloomberg and Salomon Smith Barney

Nonetheless, investors also need to understand that we can analyze ERPs across

sectors, although the history is more limited given that if we go too far back,

we suffer survivorship bias.  Admittedly, different sectors grow at different

rates, but the analysis is still revealing since we can see levels of risk

tolerance shifting.  Specifically, if one looks at the Utilities and Telecom

Services sectors (Figures 4 and 5), using the same long-term 5% growth rate that

we used for the broader S&P 500, it becomes very obvious that the required risk

premium has soared.  To some degree, we know these two industries as having been

trapped in the "Vicious Vortex" of linked credit and equity markets that we

highlighted a few weeks back, as the risk factors have manifested themselves in

both equity prices and debt market spreads.

Figure 4:

Source:  Federal Reserve, FactSet and Salomon Smith Barney

Figure 5:

Source:  Federal Reserve, FactSet and Salomon Smith Barney

Tech Price Strength -- Is It Sustainable or a Beta Bet?

Surprisingly, the tolerance for technology stock risk remains fairly unchanged,

with the Philadelphia Stock Exchange Semiconductor Index having climbed better

than 45% in the past three weeks.  While we suspect that short covering and

"beta bets" have been key factors in the recent run, we would remind investors

that semis typically do well when new capacity additions dry up as indicated in

Figure 6.  Note that when new orders for semi equipment plunge, the relative

stock price performance recovers since investors seem to anticipate better

pricing potential.  As the data shows, year over year semi equipment orders (a

proxy for capacity additions) have not yet plunged, despite announced capex

reductions by a number of leading semiconductor makers, including Intel, United

Microelectronics and Taiwan Semi.  Hence, we consider the recent tech stock

strength to be highly influenced by fears of missing out on a rally, rather than

anything more fundamental.

Figure 6:

Source:  Quest and Salomon Smith Barney

Note that capacity utilization for computers and office equipment remains quite

poor (Figure 7) despite some improved equipment and software spending growth in

the 3Q02 GDP figures.  And, as we have noted in previous write-ups, tech company

margins are highly correlated to capacity utilization.

Figure 7:

Source:  Federal Reserve and Salomon Smith Barney

We know that we keep harping on this one factor and we apologize to our readers

for doing so again -- capital spending lags corporate profits and profits are

expected to climb less than 6% year over year in 3Q02 with an expected double-

digit gain in 4Q02, while most economists continue to be worried about anemic

job growth (another important factor in capex trends).  Thus, it seems very

unlikely that we will witness a major and quick turn in capital investment

activity.  Indeed, Intel management continues to point out that its business

should recover "well after" developed economies accelerate.  While some

investors have taken the position that tech stock prices are indicative of some

new developments, such as IBM's positive comments on a stabilizing economy, we

would remind investors that stocks have been acting in a highly reactive (rather

than discounting) mode for more than two years.  Remember the double dip

rationalizations that revolved around the June and July market swoon?  Obviously

it did not predict 3Q02 GDP growth of 3.1%!  Hence, we would be taking some of

the recent tech gains off the table, rather than trying to chase the stocks as

some investors have been doing.

On the other hand, we would make the beta play in the financial stocks, which

have consistently had a better than 1.0 beta as seen in Figure 8.  The short

interest ratio for the diversified financials industry group has tripled in the

past two years vs. a less than doubling for the overall market, suggesting that

a short covering bounce is still very plausible.  Plus, valuations seem quite

moderate.  In this context, we continue to find names such as Bank of America,

Lehman Brothers, Willis Group and American Express attractive, with Morgan

Stanley and American International Group also becoming more intriguing.

Figure 8:

Source:  FactSet and Salomon Smith Barney

As a final note, investors must be impressed with the stock market's ability to

shrug off bad economic news in terms of GDP, employment and purchasing managers'

data, not to mention issues like accounting restatements and broader political

uncertainties.  In our mind, these factors along with continued strength in

copper prices, signal that the rally that we have enjoyed over the past three

weeks can continue, and we maintain our view that 1000 on the S&P 500 by year-

end 2002 is reasonable with a possible overshoot if "panic buying" sets in.

Indeed, a vigorous bear market rally would be consistent with the average 32%-

plus gains seen in the various 1974-1982 rallies despite still being in a

structural bear market during that time frame.

Skepticism still abounds about the sustainability of this recent move (despite

putting up the best ever October) and we find valuation remains compelling, with

something like 98% probability that stocks should outperform bonds (based on our

earnings yield gap work showing it to be two and a half standard deviations

below the five-year mean).  While many eyes may be peeled on the Fed and the

mid-term elections this week, we think that the various factors noted above

including sentiment, valuation and the equity risk premium all suggest that we

are poised for further market gains.

Feelings, Nothing More Than Feelings ...

An important development, which was highlighted in the PULSE Monitor and

released on Friday (November 1), is that our proprietary "Other PE" sentiment

tracker has climbed out of panic territory (Figure 9) for the first time since

early June and seems to be signaling that investors are not as concerned about

equities as they were in late September (when bond bullishness hit 90% as

illustrated in Figure 3).  While we still are very far away from euphoria mode

and only edged into neutral territory, this quantitative model should not be

ignored and does imply that investors seem a bit more willing to take some added

stock risk.  Thus, we think that a further 10%-15% broader equity market move

remains likely and could come in short order, but the ability to hold levels of

1000 or more for the S&P 500 must be considered suspect as our "Trading Places"

market rally concept (introduced last December) is still in place.

Figure 9:

Source:  Salomon Smith Barney

Companies Mentioned

American Express Company (AXP-$36.37; 1M)

American International Group (AIG-$62.55; 1L)

Bank of America (BAC-$69.80; 1M)

Intel Corporation (INTC-$17.30; 2H)

International Business Machines (IBM-$78.94; 1M)

Lehman Brothers (LEH-$53.27; 2H)

Morgan Stanley (MWD-$38.92; 1H)

Taiwan Semiconductor Manufacturing Corp. (TSM-$7.82; 2H)

United Microelectronics (UMC-$4.15; 1M)

Willis Group Holdings Limited (WSH-$30.60; 1H)

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