SB: Monday Morning Musings: Interested, or Not?

07:32am EST 24-Feb-03 Salomon Smith Barney (Tobias M. Levkovich)

See last pages for Important Disclosures

Institutional Equity Strategy

Monday Morning Musings: Interested, or Not?

February 24, 2003         SUMMARY

* The Other PE is back in "panic" territory even

Tobias M. Levkovich         without a sharp one-day market sell-off

* Weak trading volumes may not show investor

                         disinterest as is commonly thought

* Relatively high volumes reflect hedge funds and

program trading rather than trends, in our view

* The only clear trend we see is a decline in IT stock

trading volumes

* Recent Manpower survey (for 2Q03) is modestly

positive

* However, we believe Iraq is having near term

impact on hiring and investment intentions

OPINION

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

referenced figures.

When it comes time to assess whether the equity markets have hit bottom, many

pundits tend to focus on the level of investor interest in stocks.  Some seem to

seek the cathartic cleansing clarity of a major down day (such as the experience

of October 18th, 1987) in what we have dubbed a "cataclysmic crescendo of

capitulation," while others want to see the stemming of equity mutual fund

outflows as a sign that things have stabilized.   In addition, "geopolitical

uncertainties" need to subside for some to believe that things can get better,

while very few think that the uncertainty itself provides undervalued investment

opportunities.  Indeed, it is almost as if nothing can ever go right anymore

rather than the feeling three years ago that nothing could ever go wrong.  Thus,

in our opinion, while there is certainly a logical basis for concern, there does

not appear to be good reason for "irrational despondency."

In its heyday, NBC's Saturday Night Live television show introduced viewers to

Chevy Chase, John Belushi, Jane Curtain and Dan Ackroyd, to name a few, but this

writer's favorite was always the inimitable (and now deceased) Gilda Radner,

whose argumentative Roseanne Roseanadanna character, complained, "It's always

something."  While sitting back over the past few months (obsessing about the

equity markets), her sage words have come to mind time and time again.  First,

it was the bubble bursting.  Then it became a recession and terrorism, followed

by corporate scandals, crisis of confidence and deflation fears.  Now it is war,

a weakening dollar, possibly a resurgence of stagflation, rifts with allies,

anti-Americanism and budget deficits.  In other words, "It's always something."

Many investors either have surrendered to the market's whims (measured by the

aforementioned equity mutual funds outflows) or have been frozen by geopolitics.

Thus, they seem to have stopped trading stocks.  But, is that enough?  Do we

need investors cowering in fear under the desks or is simple disinterest

sufficient?  Our "Other PE" sentiment tracker (Figure 1) dipped back into

"panic" territory last week (as we outlined in last Friday's The Pulse Monitor),

indicating that investors are suitably worried, in our opinion, which

historically has been a good market entry point since the market has been higher

52 weeks later in 95% of the instances when the tracker fell below the panic

line.  But, can we really expect total investor disinterest when there are close

to 90 million American shareholders today?

Figure 1

Source: SSB Research

Since investors still have many trillions of dollars invested in the stock

market, it is difficult to argue disinterest, but one need only look at health

club television screens to notice a big difference in viewing preferences (MTV,

today, compared with CNBC, two or three years ago).  Many have written about the

end of the equity culture as being the death-knell for the stock market, with

further losses being likely, but we believe the reality is that individual

investors typically continue to sell stocks well after market bottoms have been

made.  This was true after the 1974 bottom and it was true after the crash in

1987. Hence, it is more than likely that continued equity mutual fund outflows

will be par for the course even if we all look back to October 9th 2002 as the

market's overall low point.  Indeed, after the October 1974 market bottom,

individual investors continued to exit mutual funds until 1977, while individual

investors began re-entering equity mutual funds in early 1989, almost 15 months

after the market bottom in 1987.  Thus, the fact that investors seem wary of

stocks currently is not surprising to us and is very much consistent with

previous periods.

The Volume Trap

Fascinatingly, we continue to hear technicians discuss trading volume weakness

as evidence of further market erosion potential, while others might argue that

it reflects investor disinterest as compared with the go-go days of late 1999

and early 2000.   To be fair, the advent of $600 billion-plus in hedge fund

assets (which turn over more aggressively than more staid traditional pension

fund assets) and the impact of program trading do make the analysis somewhat

more difficult, yet we found that both camps may have a point.

As can be seen in Figure 2, trading volume is off for the S&P 500 from its 2001

highs, but this likely reflects the pullback in Nasdaq volumes (Figure 3), while

the NYSE trading volumes (Figure 4) are pretty much on track with the seven-year

trend.  Moreover, when we look at S&P Information Technology sector trading

volumes, in particular, we can see where the majority of the decline has

occurred.  Essentially, one can argue that investors are still interested in

stocks, and, at the same time, suggest that they are disinterested.  While this

may seem confusing at first blush, it really is quite straightforward.

Figure 2

Source: SSB Research

Figure 3

Source: SSB Research

Figure 4

Source: SSB Research

In fact, this point is best exemplified by Figures 5 and 6, which highlight the

S&P 500's and the S&P Information Technology sector's respective trading volumes

measured in dollar value terms.  As can be seen clearly, the S&P 500's dollar

trading volume fell in half from its highs, while the IT sector experienced an

80% decline accounting for pretty much all of the overall market fall-off.

Thus, we do not think that one can make the argument that investors simply do

not care about stocks anymore as a sign that things should get better.

Furthermore, one cannot say that investors have given up on tech stocks even

though their volumes have fallen off precipitously.

Figure 5

Source: SSB Research

Figure 6

Source: SSB Research

We have listened to some thoughtful investors point out that this downturn is

different and that we cannot look at history for guidance, but we could respond

that looking at historical reference points in terms of volume may be equally

suspect in that we think these times are radically different given hedge funds,

program trading and defined benefit pension programs such as 401k plans.

Iraq

One thing that does look repetitive is the impact of Iraq on the markets, with

most investors looking back at 1991 for perspective even though the situations

are different.  In 1991, the U.S.-led coalition under U.N. resolve (and lower

U.S. popular support based on polls at that time) was simply throwing out an

invading force from Kuwait, while this time around, the U.S.-led "coalition of

the willing" without U.N. sanction thus far (and greater U.S. popular support)

must invade Iraq itself.  In 1991, Operation Desert Storm was pretty much over

within 12-18 hours (or by the time the equity markets opened the next morning)

as air superiority forced waves of surrendering troops (including units of the

much vaunted Republican Guards).  The likely Iraqi invasion in 2003 will require

ground forces taking out Iraqi army and Republican Guard positions under air

cover with Special Operations troops securing key positions including oilfields.

Consequently, it could take more time for investors to conclude that ground

forces have won the campaign than simply relying on air power.  In this context,

the market might wait for a few days before determining the victor, especially

in terms of the aftermath.

Fascinatingly, the Iraqi question has shown up in the recently released

Philadelphia Fed survey highlighting that 40% of respondents noted that Iraq was

having an impact on hiring and spending decisions.  Moreover, despite the

recently released Manpower employer survey showing that 22% of firms intend to

hire more workers in 2Q03 (21% were looking to hire in 2Q02) vs. 10% looking to

fire (same as in 2Q02), this was down seasonally from 1Q03's survey results and

probably reflected the geopolitical factor as did some commentary from The

Business Council's meetings in Florida last week.  While difficult to determine

with any certainty, the current decision-making paralysis could prove temporary

if oil prices decline in conjunction with hostilities (as was the case in 1991),

thereby freeing up incremental consumer spending.  As we have noted before, we

believe the Manpower survey is important in gaining insight into hiring trends

(Figure 7), which, in turn, leads to more spending (Figure 8).  Currently, the

change in actual jobs is about flat year over year with wage growth and lower

taxes aiding consumer spending, but job growth could become the critical

difference going forward.  Hence, economic prospects are somewhat a hostage of

the Iraq situation at the moment, in our view.  One should not interpret the

above as suggesting that once we clear the Iraq hurdle, everything will be fine,

but rather that the presently elevated equity risk premium should subside

somewhat allowing for an anticipated and most likely vigorous trading rally as

has transpired before when our Other PE dipped into panic territory

Figure 7

Source: SSB, BLS, and Manpower

Figure 8

Source: SSB and Economy.com

In our opinion, the equity market is down by roughly 10% since mid-January, due

to global uncertainty fears rather than broad-based economic issues.  As a

result, we think these rational concerns are priced into the market, but, in

order to support irrational despondency, the investment community would need to

see extreme exogenous variables kick in including oil shocks, searing terrorist

attacks and military failure.  While we cannot state categorically that they

cannot occur, we prefer top go with more probable scenarios.  Three years ago,

all was wonderful (as long as you were not bullish and held on to stocks), while

today, all is awful (and we think that bears could get mauled this time).

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ANALYST CERTIFICATION

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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