SB: Monday Morning Musings: Targeting Valuation

05:55pm EST  7-Feb-03 Salomon Smith Barney (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: Targeting Valuation

February 7, 2003          SUMMARY

        * S&P 500 P/E multiples in a range of 14x to16x has

Tobias M. Levkovich         traditionally marked the most opportune time to buy

equities.

* Our "Bulls Eye" study indicates the various

                          average and median 12 month returns following eight

different categories of P/E multiple ranges.

* We continue to favor operating earnings to

reported earnings as we believe the actions of a few

companies should not weigh on the fundamentals of

the whole S&P 500.

* Consensus long term growth expectations for the

                           S&P 500 have come down significantly from the highs

of the late 1990's and no longer appear outlandish.

* Our P/E study avoids the 1930's period as we do

          not believe we are in a period similar to the Great

Depression.

* Given that we are trading just under 16x 2003 EPS,

we believe that the equity markets are attractive

from a valuation perspective.

OPINION

See the PDF version of this note, available on GEO and FC Linx, to view all

referenced figures.

Our weekly PULSE Monitor, which we publish every Friday, focuses on four

quantitative measures that we track constantly; Price (valuation), Liquidity,

Sentiment and Earnings trends.  Moreover, we also attempt to review the non-

quantifiable Unpredictable issues, which could influence equity markets.

However, our focus today will primarily be on price or valuation, emphasizing

the often-used P/E ratio.  In particular, we intend to show investors that a P/E

ratio of 16x is not an overly expensive ratio and is indeed just about the

"sweet spot" for forward 12-month returns.

In fact, we analyzed monthly S&P 500 P/E data back to 1940 in order to look at

annual returns, following various P/E ratio levels, in order to get a

perspective on when equities look attractive.  As can be seen in Figure 1, the

best times to buy the market in terms of median or average returns, as well as

proportion of moneymaking periods, occurred when the market was trading at 14x-

16x earnings and the next best time was when the market was trading below 8x

earnings.  Not surprisingly, since it is still quite fresh in our minds, buying

stocks when the market is trading above 20x multiples has not been a rewarding

experience.  Most important, the best returns appear to be generated when the

market is trading at 14x-16x (as depicted in Figure 2).  Currently, the market

is trading just under 16x earnings.

Figure 1:

Source:  SSB Institutional Equity Strategy Research

Figure 2:

Source:  SSB Institutional Equity Strategy Research

Note: We will begin to incorporate this bulls-eye dartboard in our PULSE Monitor

on a weekly basis in order to keep investors updated as to where the market is

positioned.

In addition, Figure 3 is a frequency table that indicates the number of months

in the various P/E categories.  There is a relatively even distribution of the

data, which would suggest that we are not looking at any overly skewed

information.  Furthermore, Figure 4 provides the dates in which the market

similarly was trading within the 14x-16x P/E multiple range.  Thus, we are not

necessarily in a particularly unique valuation environment.  Undoubtedly, a P/E

ratio below 8x is certainly desirable from the perspective of buying stocks at

inexpensive levels, but we would stress that such periods generally have

involved much higher inflation and much higher interest rates.  Thus, one may

need to adjust their thinking for the current environment.

Figure 3:

Source:  SSB Institutional Equity Strategy Research

Figure 4:

Source:  SSB Institutional Equity Strategy Research

Which Earnings Should We Use For The Ratio?

While we have answered this question on a number of previous occasions, we will

do so again.  We contend that operating earnings are a better measure than

reported earnings and, over time, the two have generally been in line (see

Figure 5).   However, the measures tend to vary around recession periods as

restructuring activity and one-time write-offs occur much more frequently (see

Figure 6).  As we have noted before, a very few companies have taken massive

good will write-offs that have cost tens of billions of dollars, overwhelming

all other corporate earnings.

Figure 5:

Source:  SSB Institutional Equity Strategy Research

Figure 6:

Source:  SSB Institutional Equity Strategy Research

For instance, in 1Q02, two companies took goodwill charges that, in aggregate,

eliminated the actual earnings of the S&P 100.  Thus, if we summed up the

numbers, it would provide a very serious misrepresentation of corporate earnings

since many fine companies that truly earned money would be maligned by the

actions of a few.  In our mind, this is intellectually dishonest and leads

investors to incorrect conclusions about the overall market.  Instead, investors

should have more legitimate concerns regarding the serial restructuring and/or

goodwill write-offs of particular companies.  Indeed, reported earnings jumped

an estimated 28% last year from 2001 (according to S&P), but bears have argued

that this reflects less in one-time write-offs and thus should not be viewed as

underlying earnings growth.  We generally agree with that view, but either we

accept the growth of reported earnings if we want to use a reported earnings-

driven P/E (which we recognize has massive distortions) or use operating

earnings which attempt to normalize the data so we can look at companies as

ongoing businesses.  Plus, we have a long history of relationship (see Figure 7)

between industrial activity and operating earnings that convinces us that

operating earnings are much more representative of underlying trends.

Figure 7:

Source:  SSB Institutional Equity Strategy Research

Are Consensus Long Term EPS Estimates Out of Whack?

The investment community appears to be on the verge of cutting near term EPS

estimates, given that reduced consumer and business confidence over Iraq and all

of its ramifications has led to near term 1Q03 spending restraint.  However, we

would argue that the market has discounted a lot of these issues already.

Conversely, a very strong positive reaction post an Iraq conflict (alongside

lower energy prices) might mean that estimates move up again in a few months.

In fact, with a number of companies beginning to indicate that they no longer

intend to provide near term earnings forecasts, we decided to look at consensus

long-term EPS growth estimates for the S&P 500 by aggregating up the various

consensus analysts' estimates.  As one can see quite clearly in Figure 8, growth

rate assumptions climbed during the "bubble years" and have since come slumping

lower, back to more "normal" levels seen in the early 1980s or early 1990s.

While admittedly still optimistic, they no longer appear outlandish, in our

opinion, with bottoms-up estimates almost always exceeding top-down forecasts.

Figure 8:

Source:  SSB Institutional Equity Strategy Research

Why The Study Does Not Encompass the 1930s?

As noted above, we took our study back to 1940 in order to capture the effect of

World War II and the beginning of the Cold War, but we did not take the study

back to the 1920s, which would have incorporated the awful stock market of the

1930s.  Our rationale reflects a belief that the U.S. is not headed for another

Great Depression, and also recognizes that monetary policy is markedly

different.  As one can see in Figure 9, provided by SSB economist Robert

DiClemente, total money supply is very much arguing for some rebound in

inflation, while part of the problem in the 1930s was the restriction of money

supply.  Indeed, one could argue that deflation concerns could have been a

greater worry in the first half of the 1950s than today and P/E multiples were

above 8x back then.

Figure 9:

It's Not Like the 1930's

Source:  FRB and BLS

In many cases, comparisons with the 1930s have some questionable fundamental

underpinnings in that there were no margin limits, no SEC, no bank deposit

insurance and no disintermediation of lending activity by the capital markets

from the banking system (which led to banks collapsing and savings being wiped

out since there was no FDIC or FSLIC in place at the time).  As a result, we

consider valuation comparisons to that period to be baseless because the

investing environment is so radically different, as we see it.

In summary, we appear to be back in that P/E valuation "sweet spot" but we

continue to hear arguments of over-valuation.  Our earnings yield gap analysis

also argues for stocks over bonds.  We see earnings growth and even improving

capital spending, but investors seem resigned to nothing getting better.  And,

our proprietary sentiment index is getting close to panic levels again which

also intimates that one should be stepping back into stocks.  While we are aware

that the uncertainties over Iraq are weighing on investor decision-making, we

believe the stage is being set for a powerful rally whose trigger may be the

success of unilateral U.S. military action, unwavering U.N. backing for a

military option, a peaceful Saddam exile or something that we have yet to

identify.  As we highlighted last week, investor risk tolerance is at a low ebb

and that usually indicates opportunity, not a reason to retreat.

ANALYST CERTIFICATION

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.

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