|
|
||
|
Monday Morning Musings: The 2003 Outlook
Analyst: Tobias M. Levkovich
Institutional Equity Strategy - Salomon Smith Barney - Monday Morning Musings: The 2003 Outlook
December 6, 2002 SUMMARY * We expect 2003 to be another year of "muddling Tobias M. Levkovich through" characterized by trading rallies and market volatility. * Our year end 2003 index targets are unchanged, at 1,075 for the S&P 500 and 10,375 for the DJIA. * Scarcity of business drivers and investor current income argue convincingly for more government influence on business conditions and a focus on dividends * Our sector recommendations are unchanged; we continue to overweight Financial and Consumer Discretionary stocks, and are underweight Consumer Staples, Technology, and Utilities. * We expect heightened political activity in 2003 to play a key role, particularly on taxation policy and tort reform, among other issues. OPINION
See the PDF version of this note, available on GEO and FC Linx, to view all referenced figures.
Given that we are less than a month away from New Year's Day, we thought that a peek into 2003 was appropriate and that this would be an appropriate time to provide a more detailed outlook regarding the business environment, market targets, sector and industry group perspectives, and some of our favorite individual names. Note that we are not making any changes to our sector viewpoint at this time. Moreover, we expect that 2003 is likely to be another year of "muddling through" as we continue to absorb the aftermath of an investment-led boom in the late 1990's, a lack of domestic pent-up consumer demand, sluggish overseas economies, the uncertain impact of terrorism and war, and continued pressures on overly optimistic Street expectations (especially when it comes to yesterday's favorite industry, technology).
Additionally, the culmination of a number of trends suggests that 2003 may be "The Year of the Government." Issues like taxation policies (at the federal, state and local levels), tort reform, health care, defense and security-related spending, energy industry programs, business regulation guidelines and even Social Security should all play an enormous role in the stock market in the coming year. Indeed, the resignations of Treasury Secretary Paul O'Neill and White House economic adviser Larry Lindsey are being interpreted in some quarters as a statement from the Bush administration regarding its economic concerns in advance of the 2004 elections. In particular, Mr. O'Neill was less than keen on new stimulus bills without a major overhaul of the tax system, while many on the Street were not impressed with Mr. Lindsey acting as a spokesman for the White House on economic policy. Furthermore, some political commentators explain the Republican sweep in November 2002 as a message from voters that government is now viewed as a problem solver rather than as the interfering problem itself, which was the case during the Reagan years. In fact, many political observers believe a new era of "big government" is at hand and that the establishment of the Homeland Security Department is just the first step of increased government involvement. While it is fair to say that federal government discretionary spending (only about 7% of the budget) cannot truly change the GDP landscape, we think it can have impact via taxes, laws, the regulatory environment and the judiciary.
While we are not political scientists making long-term socioeconomic projections about the role of government, we do think that policy decisions and legislative actions over the next six-to-12 months could have meaningful impact on various industries. Yet, investors need to remember that political pressure is "situational" and can shift, thereby adding to market volatility. For instance, the issue of eliminating or reducing the double taxation of dividends has received enormous attention of late and clearly has stock-picking ramifications. Likely attempts at tort reform would heavily influence decisions about insurance providers, although we believe that Republican efforts will be more targeted, with a separate focus on individual issues such as asbestos and medical malpractice, etc. While limitations or caps on asbestos claims could benefit the property & casualty insurance and reinsurance industries, even the specter of legislative change could force greater legal settlement activity, as might already be the case at Sealed Air, Halliburton and Honeywell. In addition, bringing forward the 2004 tax cuts for lower and middle income Americans, an oft stated goal of the Bush Administration and many Congressional Republicans, would be another boost for the U.S. consumer who is currently facing rising health care premiums and possibly higher state and local taxes (due to 2003-04 budget shortfalls). Overall, the combination of increased hiring activity (based on the recent Manpower survey) , lingering refi benefits, along with lower federal taxes and reasonable pay increases (up 2.9% year over year in November) should sustain personal consumption expenditures and thereby support Consumer Discretionary stocks. Finally, defense spending is likely to climb further in response to current geopolitical concerns. While the ultimate macroeconomic impact is less clear, discussion and resolution of these and other issues have could lift ad/or buffet stocks in the near term -- which will require tactical responses on the part of investors.
Lastly, monetary policy is now beginning to kick in "across the pond" following the ECB rate cut last week. Thus, the combination of stimulative monetary and fiscal policy can offset many of the fears of deflation, excess capacity, and war. However, the key risks remain energy shocks and terrorism.
Market Targets and Valuation
Over the next five years we expect compound annual returns from stocks of around 7%, with volatility around that trend such that stocks could trade up 20% or down 20% during any given year (we explain this view in more detail in our Trading Places report series published over the past year). Accordingly, while the trajectory is up and thereby generally bullish, investor expectations may continue to shift erratically over the near to intermediate term. Therefore, a close watch on investor sentiment and expectations seem to be critical to determining such volatility swings in the year ahead. In this context, we will be using our "Other PE" sentiment tracker (introduced in July) and our new "U.S. Cyclical Expectations Model" (released last week in Portfolio Strategist) as key tools in this endeavor.
Our Dow Jones Industrial Average year-end 2003 target remains 10,375 while our S&P 500 target is unchanged at 1,075. The S&P 500 target is based on our price/book analysis, which incorporates our 2003 S&P 500 operating EPS estimate of $52.10. We then slash this number by 20% for any options or pensions charges (given investor concerns). We then subtract the dividend payout of an estimated $17.00 to arrive at a projected market weight-adjusted 2003 book value of 355. Next, we assumed inflation is at a 3% run rate by year-end 2003 (which may be too aggressive, but we are trying to be conservative in arriving at our market objectives), which suggests a 3.0x price/book valuation based on our trend-line work seen in Figure 1.
Figure 1:
Source: Factset and SSB
We also look at price/sales as a back-up mechanism. Many investors believe that a price/sales ratio of 1.2x-1.3x is lofty compared to historical valuation ratios. Yet, we think that one needs to compare valuation against both inflation rates and debt levels. In previous periods of muted inflation (and thereby low interest rates) like the late 1950's and early 1960's, the price/sales ratio was quite similar (Figure 2).
Figure 2:
Source: Economy.com
Moreover, when one considers federal government debt levels as a percent of GDP, we are back to the 1960s as well, which should allow for fiscal stimulus to help the economy along (Figure 3). Thus, the valuation issues is not as dire as many would like investors to consider.
Figure 3:
Source: Economy.com
Additionally, when we consider valuation, we also rely on our earnings yield gap models that suggest that we could see further stock price appreciation, possibly at the expense of Treasury bonds. At more than two standard deviations below the mean (Figure 4), there is more than a 95% probability that stocks will outperform bonds. And, while some question the use of operating earnings or their predictability, we would argue that past crises, including Cold War brinkmanship (such as Korea, Vietnam, the Cuban Missile Crisis) and Middle Eastern conflicts (1948, 1956, 1967, 1973, 1990-91, etc.) have made things difficult and confusing before with varied impact on the equity markets. Indeed, accounting was also a factor in the latter 1970s with inflation affecting inventory-driven reported income vs. underlying operating profits, but stocks bottomed in late 1974 anyway. Moreover, terrorism has been a global issue (although not an American one) for decades with the IRA, the Red Brigades, the Front Liberation de Quebec, the ETA, the Baader Meinhof and Shining Path gangs, not to mention Black September. Thus, we do not seem to be at quite the crossroads that many perceive. Terrorism is a dire and horrible threat but not one that the world and equity markets have never overcome, although we recognize that America is a powerful newcomer to the fight.
Figure 4:
Source: SSB
Finally, there seems to be a Pavlovian fear that whenever interest rates rise, stocks decline. Thus, the expectation that 10-year Treasury rates will climb to 5.0% by year-end 2003 (the forecast from SSB's economists), might be perceived as a major threat to stock prices. However, in the 87 years since 1915, the stock market has climbed in 56 of those years, the majority of which occurred during periods of rising interest rates (36 times during periods of rising interest rates versus 22 when rates were declining) since earnings were rebounding as well. We forecast that S&P 500 operating EPS should grow 7% year over year in 2003, but that Street expectations might still be too sanguine for technology companies where it still seems as if investors continue to hope for salvation.
Figure 5: Historical Discount Rate and Stock Price Movements
Source: Global Financial Database and Salomon Smith Barney
Sector and Stock Focus
Our sector views can be found in Figure 6. We have not changed our positive stance on the Financials and Consumer Discretionary stocks as we remain overweight both sectors. We continue to have a more upbeat view of Health Care, especially drug names, due partially to the Republican congressional victory and our view that any prescription drug legislation that is enacted will not be as onerous to the industry as it would be under a Democratic Senate. Furthermore, the generics risk should be less intensive in 2003 due to fewer blockbusters coming off patent compared to 2002. In this context, we continue to see Banks and Diversified Financials as attractive areas of investment including names like Wells Fargo, JP Morgan and Morgan Stanley. Moreover, in this more volatile market that we believe has roughly 7%-8% upside in 2003, positive pricing power and some relief on the asbestos front should clearly benefit insurance companies like American International Group and Ace Limited. Moreover, any such liability relief also could assist more Rust Belt-oriented companies.
Figure 6:
Source: SSB and Factset
Many investors worry that spreads could tighten up and hurt financial stocks, yet history suggests that the correlation between relative stock price performance of the Financials sector and yield curves is not great. Indeed, credit losses are more of a concern and they do not seem as threatening this go round due to much lower interest expense as a percent of corporate cash flow vs. 1990-1991(see Figure 7).
Figure 7:
Source: SSB Economic and Market Analysis
In the Consumer Discretionary sector, we continue to think discounters can win share given the value-conscious consumer, with names like Wal-Mart, Home Depot and Kohl's coming to mind. In addition, beaten-up names like Lennar and Comcast, which have pricing power, seem reasonable as well. Plus, broadcasters such as Viacom should benefit from a stronger advertising market.
However, we remain concerned about the Utility, Technology and Consumer Staples sectors (where we remain underweight). The latter is beginning to lose pricing power, in our view, as competitive pricing appears to be manifesting itself in cigarettes, diapers, soft drinks, snack foods, burgers and recently wine. For exposure to Technology, we continue to think that Dell Computer offers the best option, although the integration story at Hewlett Packard remains interesting. We also see some opportunities later in 2003 for semiconductor names, but we think it is inopportune to buy into these names now given the recent rally and continued weak fundamentals.
Moreover, we consider many investors to be seemingly complacent as to the growing risk to what has long been perceived to be stable growth industries (such as Consumer Staples). And, within the Telecom Services sector, much will depend upon the possible emergence from bankruptcy of a potentially debt-free WorldCom that could under-price the regional Bell operating companies as well as AT&T. Within the Energy sector, we prefer the energy equipment and services names, while we favor defense stocks in Industrials.
Dividends Add Up
We remind investors of our thematic view (which we have discussed for almost three months) regarding the growing importance of dividend-paying stocks. Investors seem to want to be paid something today and not just wait for the future appreciation. That desire will only grow alongside an aging investor population that will be seeking greater income. As we have noted in previous write-ups, companies have begun to recognize this need to attract and retain investors by virtue of dividends. As can be seen in Figure 8, companies have begun to lift their dividends in advance of earnings for the first time in 30 years. Thus, it may not be that far off before we see companies like Microsoft, Cisco and Intel pay out dividends, in our opinion.
Figure 8:
Source: Factset and Economy.com
While many investors are focused on the double taxation of dividends debate, we think that its elimination would only add fuel to the fire, as more investors already seem intent on fixing the "current income scarcity problem" of low interest rates and low (and often no) dividend yields. Some investors and management teams (generally growth-oriented ones) seem unwilling to accept the notion of paying out dividends due to a tacit admission that it implies less growth opportunities going forward and a tax inefficient manner to return money to shareholders. The latter argument fails our smell test since most stocks are either owned institutionally or in tax-deferred accounts, while many fast growers pay dividends too, with some academic studies arguing that dividend- paying growth companies outperform non-payers.
Risk Aversion
The one factor we find disconcerting is the willingness to lower exposure to equities due to a higher equity risk premium (see Figure 9 for a long history of observed ERP) and that investors may be "doubling-down" their equity exposure by buying very defensive sectors in case of war, terrorism, energy shocks, further economic weakness, etc. The fact that the observed ERP is at its highest level in more than 20 years already reflects investor caution, and thus many investors have been buying bonds over stocks. But to then get even more defensive with cautious stocks picks seems like a bet on everything going wrong. That does not seem to be an objective or balanced view, but an overwhelmingly biased and pessimistic one with no room for market rallies.
Figure 9:
Source: SSB Economic and Market Analysis
While we have strategic concerns such as potentially optimistic investor expectations regarding a quick recovery back to those double-digit annual stock market returns (of the latter 1990s) and investor hopes-for technology leadership, we think that tactical bullishness is appropriate with an eye towards participating in the big trading rallies. Should we get a late 2002 money manager "panic buy" as investors sprint for a year-end beta run, we might get some retrenchment in the early part of 2003 and one has to be aware of the volatility risks which we highlighted upfront. In this regard, one might have to be more nimble trading stocks in 2003, similar to 2002, but government and dividend themes will likely play a role in those shifts, in our view.
************************
I, Tobias Levkovich, hereby certify that the views expressed in this research report accurately reflect my personal views. I also certify that I have not been, am not, and will not be receiving direct or indirect compensation in exchange for specific choices made in industry or sector selections.
COMPANIES MENTIONED
ACE Limited (ACE-$32.17; 1H)
AT&T Group (T-$28.00; NR)
American International Group (AIG-$60.49; 1L)
Cisco Systems Inc (CSCO-$14.18; 1H)
Comcast Corporation (CMCSK-$23.86; 1H)
Dell Computer (DELL-$28.65; 1H)
Halliburton Company (HAL-$20.19; 1S)
Hewlett-Packard (HPQ-$18.83; 1H)
Home Depot, Inc. (HD-$26.10; 1M)
Honeywell International (HON-$24.37; 1H)
Intel Corporation (INTC-$18.71; 2H)
JP Morgan Chase (JPM-$24.43; 1M)
Kohl's Corporation (KSS-$61.88; 1M)
Lennar Corp. (LEN-$49.45; 1H)
Microsoft Corporation (MSFT-$55.47; 1H)
Morgan Stanley (MWD-$42.81; 1H)
Sealed Air (SEE-$36.57; 1H)
Viacom Inc. (VIAB-$45.15; 1M)
Wal-Mart Stores, Inc. (WMT-$53.04; 1L)
Wells Fargo (WFC-$46.05; 1M)
IMPORTANT DISCLOSURES
Analysts' compensation is determined based upon activities and services intended to benefit the investor clients of Salomon Smith Barney and its affiliates ("the Firm"). Like all Firm employees, analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the Private Client Division, Institutional Equities, and Investment Banking.
The Firm and its affiliates, including Citigroup Inc., provide a vast array of financial services in addition to investment banking, including among others corporate banking, to a large number of corporations globally. The reader should assume that SSB or its affiliates receive compensation for those services from such corporations.
For securities recommended in this report in which the Firm is not a market maker, the Firm usually provides bids and offers and may act as principal in connection with such transactions.
Important disclosures regarding the companies that are the subject of this research report are contained on the Firm's disclosure website at www.ssbgeo.com. Private Client Division clients should refer to www.salomonsmithbarney.com/research and can obtain disclosure information from their Financial Consultants. In addition, valuation methodologies and associated risks pertaining to price targets, as well as other important disclosures, are contained in research reports and notes published on or after July 8, 2002.
Salomon Smith Barney Equity Research Ratings Distribution Data current as of 30 September 2002 Outperform In-line Underperform SSB Global Equity Research Coverage (2916) 36% 39% 25% % of companies in each rating category that are 48% 47% 38% investment banking clients
***************************** For purposes of NASD/NYSE ratings-distribution-disclosure rules, our Outperform rating most closely corresponds to a buy recommendation; our In-line rating most closely corresponds to a hold/neutral rating; and our Underperform rating most closely corresponds to a sell rating. Because our ratings are based on the relative attractiveness of a security within an industry or analyst-coverage area, however, Outperform, In-line, and Underperform cannot be directly equated to buy, hold/neutral, and sell categories. Accordingly, your decision to buy or sell a security should be based upon your personal investment objectives and only after evaluating the stock's expected relative performance and risk.
Guide To Investment Ratings: Stock ratings are based upon expected performance over the next 12 to 18 months relative to the analyst's industry coverage universe. An Outperform (1) rating indicates that we expect the stock to outperform the analyst's industry coverage universe over the coming 12-18 months. An In-line (2) rating indicates that we expect the stock to perform approximately in line with the analyst's coverage universe. An Underperform (3) rating indicates that we expect the stock to underperform the analyst's coverage universe. In emerging markets, the same ratings classifications are used, but the stocks are rated based upon expected performance relative to the primary market index in the region or country. Our complementary Risk rating system takes into account predictability of financial results and stock price volatility. L (Low Risk): high predictability of financial results and low volatility; M (Medium Risk): moderate predictability of financial results and moderate volatility; H (High Risk): low predictability of financial results and high volatility; S (Speculative): exceptionally low predictability of financial results and highest risk and volatility. In addition, in the major markets our Industry rating system is based on each analyst's evaluation of their industry coverage relative to the primary market index in their region. The industry ratings are Overweight: we expect this industry to perform better than the primary index for the region in the next 12-18 months; Marketweight: we expect the industry to perform approximately in line with the primary index for the region in the next 12-18 months; and Underweight: we expect the industry to perform worse than the primary market index for the region in the next 12-18 months.
Securities recommended, offered, or sold by SSB: (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. Although information has been obtained from and is based upon sources SSB believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute SSB's judgment as of the date of the report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security.
Investing in non-U.S. securities, including ADRs, may entail certain risks. The securities of non-U.S. issuers may not be registered with, nor be subject to the reporting requirements of the U.S. Securities and Exchange Commission. There may be limited information available on foreign securities. Foreign companies are generally not subject to uniform audit and reporting standards, practices and requirements comparable to those in the U.S. Securities of some foreign companies may be less liquid and their prices more volatile than securities of comparable U.S. companies. In addition, exchange rate movements may have an adverse effect on the value of an investment in a foreign stock and its corresponding dividend payment for U.S. investors. Net dividends to ADR investors are estimated, using withholding tax rates conventions, deemed accurate, but investors are urged to consult their tax advisor for exact dividend computations. Investors who have received this report from the Firm may be prohibited in certain states from purchasing securities mentioned in this report from the Firm. Please ask your Financial Consultant for additional details. |
||
|
Ogni lettore deve considerarsi responsabile per i rischi dei propri investimenti e per l’uso che fa delle informazioni contenute in queste pagine. Lo studio che propongo ha come unico scopo quello di fornire informazioni. Non e’ quindi un’offerta o un invito a comprare o a vendere titoli. Ogni decisione di investimento/disinvestimento è di esclusiva competenza dell'investitore che riceve i consigli e le raccomandazioni, il quale può decidere di darvi o meno esecuzione. 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. |
||
|
|