Monday Morning Musings: A Geopolitical Funk - Been There, Done That!

Analyst: Tobias M. Levkovich

Institutional Equity Strategy                                                  

Monday Morning Musings: A Geopolitical Funk - Been There, Done That!           

March 7, 2003             SUMMARY                                              

* We explore the complexities and sensitivities of   

Tobias M. Levkovich         the geopolitical environment - including terrorism 

risk, war fears, protests, higher energy prices -  

and the effect on the stock market and equity risk 

premium.                                           

* We reiterate our "Trading Places" thesis which     

states that sharp upward stock price movements are  

likely; and are standing by our 2003 S&P 500 target

of 1075.                                           

* Iraq resolution should allow for the equity risk   

                    premium to subside and provide for threatening     

energy prices to ease back down from war           

premium-adjusted levels. Yet, we still believe that

         we are likely to be restrained from quick emergence

of another secular bull market.                    

OPINION

Please see the PDF version on FC Linx and GEO to view figures.

Just think about the investment climate.  Terrorism concerns, international war

fears, spiking energy prices, warmer relations between Moscow and Washington,

Mideast turmoil, U.S. troops stretched out in various overseas involvements,

improved Chinese/American cooperation, tension on the Korean Peninsula, virulent

and large anti-war protests, emerging countries' nuclear ambitions, religious

strife overseas, Asian instability, a stock market still dealing with the

aftermath of a bubble bursting, budget deficits, a new Cabinet-level U.S.

government department, the growing impact of media providing global information

flow, incredible technological advances, excess capacity, economic uncertainty,

security concerns about nuclear plants and anti-Americanism.  For the most part,

this appears to be a pretty difficult environment for most investors to address.

Sentiment is obviously poor and the individual investor's appetite for stocks

diminished markedly.  Sounds familiar?  Yes, just as you guessed, we are

describing ... the 1970s!

Figure 1 provides an interesting time line with various data points to help

investors recall the geopolitical dynamics of the 1970s in order to better

comprehend that we have been here before.  The current considerably angst-filled

environment is not terribly new and markets have survived them before.  The

aftermath of the "Nifty-Fifties" stock price collapse and the 1973-74 energy

crisis-related economic swoon (which took down equities as well), alongside the

resignation of both the U.S. Vice President (first) and the President (later on)

devastated consumer, corporate and investor psyches.  The war in Vietnam and

Cambodia was broadcast via TV into every living room, as was the terrorist

attacks at the Olympics in Munich along with the spate of airline hijackings.

Roe vs. Wade and the first test-tube baby split the nation on religious/social

grounds, while "Bloody Sunday" in Northern Ireland underscored religious strife,

all the while India joined the nuclear arsenal family by successfully testing an

atomic bomb in 1974.

Figure 1

Source: SSB

Consequently, as we have outlined now for 15 months, since we published our

first "Trading Places" report, we should learn from the 1970s about meaningful

trading rallies since that is what we should be expecting to see in the next few

years as opposed to a steady upward trajectory as was the case from 1982 through

1999.  Moreover, as occurred in 1974, we did not see a cataclysmic crescendo of

capitulation in the form of a massive one-day sell-off to signal the equity

market's bottom in October.  In fact, the market turned with a whimper and then

with a growing sense of disbelief -- by July 1975, the market had climbed more

than 50% from the October 1974 trough!  Accordingly, while we may have what some

consider to be a very optimistic 2002 target of 1075 for the S&P 500, roughly

30% above current levels, that run would be far less than what we saw back in

1974-75 and would be about the average of the six rallies experienced from

October 1974 through June 1982 (Figure 2), before the secular bull market began.

Indeed, the stock market doubled over that eight-year period off its bottom

prior to the summer of 1982.

Figure 2

The S&P 500's Trading Rallies from 1974 to 1982

Source: SSB

Furthermore, when we calculate dividend discount models, earnings yield gaps,

price/book valuations (against inflation) and even our recently introduced debt

adjusted P/E structure (see last week's Monday Morning Musings), the 1050-1100

range is not that far-fetched at all.  Indeed, were the stock market to

appreciate 30% in a powerful trading bounce, the S&P 500 would still be 30%

below its March 24, 2000 "bubble" peak.

Much of our comfort with the comparison can best be illustrated by observing the

elevated equity risk premium seen in Figure 3, which has moved up to 1970s-like

levels.  Back then, the various geopolitical and social issues were impacting

economic activities and the same is true currently (for instance, the recent

employment data).  And, while one could argue that Americans have been attacked

on the home front this time, that view may not be accepted by the families of

56,000 soldiers killed in Vietnam and Cambodia or the former U.S. hostages in

Iran (1979) or the U.S. merchant vessel crew of the S.S. Mayaguez seized by

Cambodian patrol boats in 1975.

Figure 3

Source: SSB

To be fair, there are differences between the 1970s and the 2000s:  There is no

Watergate, no spiraling inflation.  P/E multiples are about twice the levels

seen in 1974, but inflation is less than half today also.  Domestically, the

U.S. military is held in high esteem, as is the office of the Presidency.  And,

while energy prices have jumped, the increases are not as great as they were in

1973-74, 1979-80 or even early 2000 (Figure 4).  In fact, many may not remember

that oil prices jumped from less than $2/barrel in late 3Q73 to $12/barrel a

year later.  Thus, the move in oil prices from $23/barrel a year ago to $37-ish

currently is far from equivalent.

Figure 4

Source: SSB

As one can see pretty clearly in Figure 5, the equity market began to climb in

1975 due to the aforementioned energy price spikes subsiding..  Given the

elevated levels of risk premium today as a result of the tech/telecom bubble

bursting, Iraq war concerns, higher energy anti-Americanism, a weak dollar,

terrorism, excess capacity, a new Cabinet-level department, budget deficits,

anti-wear protests, Mideast turmoil, overseas military presence in many

countries (Japan, Korea, Germany, Afghanistan, the Philippines, Saudi Arabia,

Kuwait, Qatar, etc.) and so on, we have been there and done that as investors.

Figure 5

Source: SSB

Perspective is a factor that tends to get blurred in today's fast-paced world of

sound-bites, media blitzes and trigger-happy traders with instant gratification

being the most valued service.  Yet, when we actually look at past events and

see many similarities, they cannot and should not be ignored.  We have discussed

valuation a number of times over the past few weeks in our writings, reviewed

the American consumer, and reviewed data demonstrating that capital spending has

indeed recovered.  Yet, we believe investors remain paralyzed by what we and

apparently others have dubbed "Iraqnaphobia."

The last time Iraqnaphobia hit was when Iraq invaded Kuwait and Saddam Hussein

promised the world "the mother of all battles."  This time is different than in

1990-91 in that some members of that coalition have balked at participating

again and regime change/disarmament is far more complicated than removing an

invading army from another's sovereign country.  Yet, clearly Iraq resolution

should allow for the equity risk premium to subside and provide for threatening

energy prices to ease back down from its war premium-adjusted levels.

Nonetheless, given all the other issues mentioned, we are likely to be

restrained from another secular bull market in short order as was the case in

the 1970s.  Other geopolitical issues will come to the fore such as North Korea,

a still divided Venezuela and other potential trouble spots.  The war on

terrorism and rogue states could last awhile and we will have to become more

savvy traders, but with 30% potential upside trades vs. 3%-plus Treasury yields,

the choice seems obvious at such elevated risk premiums.

Last week, we published a research note about war-proofing one's portfolio, but

we would remind investors about the market's post-1991 Operation Desert Storm.

Within three months, the S&P 500 had climbed just about 20% (Figure 6), led by

Financials (up 40%-plus), Healthcare (up 25%) and Consumer Discretionary (up

25%), with energy-related and household products stocks lagging badly.  While we

are unlikely to experience the same type of Fed-induced interest rate help as

was seen in 1991-92, we are also unlikely to see Fed-inspired curtailment of

economic momentum in order to ensure that deflation is only something we read

about in history books.  Consumer Discretionary names should do well if energy

prices fall and corporations rescind near term hiring freezes as a result of the

current Iraq uncertainty.  In addition, some capex that has been held up could

be released.  And, the Financials would provide the financing of inventory and

capital spending needs through commercial & industrial loans.  Thus, the

Financials act as a lower valuation means to participate in capital investment,

in our opinion, without potentially over-paying for some technology names that

likely would rally as well.

Figure 6

Source: SSB

---------------------------

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.

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.

Mar-07-2003 22:52 GMT

Source SALB Salomon Brothers

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