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Monday Morning Musings: Long Term vs. Short Term Investing Analyst: Tobias M. Levkovich Institutional Equity Strategy Monday Morning Musings: Long Term vs. Short Term Investing April 21, 2003 SUMMARY * The "buy and hold" mantra persists, but 6%-7% Tobias M. Levkovich long term equity returns likely * We think that "timing" will be even more rewarding than "buy and hold" for the next few years * Sentiment shifts are likely to be the biggest factor in timing entry/exit * We are encouraged about a continued trading rally into the summer * We would watch semiconductor prices for some guidance as to broader earnings trends, and also would keep any eye on geopolitical events * We prefer financial stocks, underperforming consumer areas such as hotels, leisure and media, and semiconductor and semi equipment names OPINION Please see the PDF version on FC Linx and GEO to view figures. While it may be considered an understatement to suggest that the investment climate that existed for more than 20 years changed dramatically in the past three, we think that equity investors now have to adjust their investment expectations yet again. In particular, the view that stocks are the best investment over the long term continues to persist, which argues that one should buy a portfolio of equities and hold them for 10 or 20 years since most investors tend to be lousy market timers. Moreover, churning one's portfolio is deemed to be a great way to lose money. Unfortunately, in the wake of the bubble's demise, the "buy and hold" investment strategy may have kept investors in certain stocks that were considered to hold the keys to our economic future only to be severely disappointed as these names fell 90% or more from their New Economy paradigm highs. The certainty of this "buy and hold" mantra had been assured since 1975 given outstanding returns for a generation of investors. Thus, the notion of shifting investment styles was perceived as near sacrilege. Stocks And EPS Are Joined At The Hip However, the debate over investing has taken on a new life. As one can see from Figure 1, stock prices for the most part climb in line with nominal EPS growth over time. Indeed, we have pointed out before that the R^2 correlation between the S&P 500's performance and its aggregate operating earnings is 0.85, dramatically higher than any other market driver we have looked at (including interest rates). Furthermore, academics have argued that earnings growth cannot exceed nominal GDP growth for any extended length of time. Accordingly, the angst over low inflation (and even deflation fears) has been a critical issue for the potential returns from the stock market as nominal EPS growth would be constrained. Moreover, the relatively low dividend yield offered by the S&P 500 means that the other important contributor to stock market returns may be below par vs. its historical role. Figure 1: Source: Smith Barney Institutional Equity Strategy Indeed, if one looks at Figure 2, one can see that the over the 1900s, stocks provided various returns depending upon the decade, but they generally appreciated in line with earnings trends with a few notable exceptions often affected by interest rate shifts. In the latter 1990s, valuation expansion was the greatest driver for stock price appreciation, but this simply was not sustainable after strong performance in the prior 15 years. In fact, when the assumed earnings growth potential proved to be excessive, stock prices fell even more sharply due to required multiple contraction. Think of a single company's stock where investors had a 25% growth rate assumption trading at $35 on a $1.00 EPS assumption and then we find out that it cannot grow better than 10% and only will show EPS of $0.70 this year; one would expect at least a 50% one-day stock price plunge on such news. The same obviously can happen to the broader markets. And, thus, expecting a similar 20-year run going forward seems overly optimistic. Figure 2: Source: Smith Barney Institutional Equity Strategy Future "Normal" Annual Stock Returns May Only Be 6%-Plus If we consider the likelihood that "normal" future real GDP growth is more like 3.0%-3.5% as opposed to the better than 4.0% growth experienced in the late 1990s and that inflation will be in the 2.0%-3.0% range, one would come to the conclusion that annual stock price appreciation may be in the 6.0% area with dividends providing the balance of stock market returns. Given a current S&P 500 dividend yield of just under 2.0% (although we would note that the average yield of dividend paying stocks in the S&P 500 is 2.5%), we come to a longer- term return base of just under 8% per annum. Investors need to note that even if the basic assumptions outlined here are correct, history would point out that earnings growth generally lags economic growth due to earnings dilution from increased share counts and the recognition that much of future growth may come from companies that are not yet public entities. For instance, back in 1980, we doubt that investors would have calculated the growth of Intel, Microsoft or Cisco Systems into any of their market expectations. Thus, something in the order of 6%- 7% equity market returns over the long haul may be appropriate. While this is obviously less than the returns seen in the past two decades, it sure beats the past three years and generates more than 1.5x the coupon return available from 10-year U.S. Treasuries. Thus, we still prefer stocks to bonds, especially given our belief that there is growing risk to bond prices (given inflation concerns, heavy 2H03 government debt issuance and the need to attract foreign buyers). On the other hand, despite this seemingly benign trend line rate of return, we anticipate significant volatility around the trend line; this was the case after the market hit its bottom in 1974 (Figure 3), before a new bull market emerged in 1982. After the 1973-74 bear market trough, individual investors abandoned stocks for years, and we could see a repeat of that action given severe losses since the 2000 highs. This, in our opinion, will not mean the end of stock investing as some fear (the so-called "death of the equities cult"), but the investing will be left to the professionals. In many respects, such an environment should be welcomed by active managers who can now show their mettle as opposed to trying to chase benchmarks that were constantly shifting as the indices were changing out constituents almost weekly. As a reminder the six trading rallies from late 1974 through 1982 generated 32% average gains versus the trendline longer-term return of 9.4%. Hence, a repeat could occur following the October 2002 trough. Figure 3: Source: Smith Barney Institutional Equity Strategy To some degree, the emergence of the hedge fund community with alpha-type investment styles (and $600 billion in assets) is forcing a change in the investment community as benchmarked equity fund managers may need to be more active in order to hold on to assets. Consultants may need to back off their tight advisory grip on portfolio managers who may need to be more aggressive than normal at times and more conservative at others. Nonetheless, such portfolio dexterity will take time to adopt and will be resisted, in our view. As a result, we think that "timing" will be even more important than "buy and hold" for the next few years. This view is consistent with our "Trading Places" stance taken in December 2001, and we have witnessed a number of converts join our thinking of late, but we believe that we remain in the minority. Many investors still see things in stark contrast. They think that we are in either a bull market or a bear market, and that one should buy stocks in a bull market and hang on to bonds in the bear phase. In a certain respect, we may very well be in "no man's land" where active investing becomes crucial. The problem is that "buy and hold" has become ingrained into our thinking, but consensus thinking is generally quickly reflected in stock prices. Nonconsensual thinking, however, is often rewarded. So, Where Is The Consensus? In discussions with investors over the past four weeks we have heard various questions and therefore believe we have some insight into consensus views. In essence, there are five key perspectives that emerge: * The market is range-bound with trading likely to be in the 800-950 area (using the S&P 500 benchmark); * Treasury bonds are headed lower (yields rising); * The economy will be soft, but second half recovery is expected * Earnings expectations are still too high; and * Technology stocks are over-valued as capital spending will be muted Let us acknowledge that the consensus is not always wrong, yet we must look at the implications of the view and how it plays into stocks. The range-bound market suggests that one should be a buyer at the low end and a seller as we near the high end, but that does not seem to be the case in practice given that investors get very nervous as we get close to testing old lows (which can be seen in various bull/bear surveys, the VIX, etc.). Furthermore, despite fears of higher bond yields, Market Vane's T-bond bullishness is still at 74% even as we know that second-half 2003 government debt issuance likely will top $500 billion and possibly cause some supply/demand disruption which could push up yields. If extreme events (such as searing terrorist attacks) occur, the equity market arguably could break downside support, with the bigger surprise being that the upside resistance gets broken in the face of deep investor skepticism. Second half economic recovery is anticipated but many investors have heard that story for two years running only to be disappointed. Hence, there is a fair degree of cynicism about buying stocks ahead of that development. Investors simply are in a Missouri ("show me") state of mind. But, in order for economic recovery to gather some momentum, capital spending and technology investment needs to pick up since this was the area that fell back in 2000-01. As a reminder, the recession was capital spending induced and thus some recovery is needed. In this context, the falling out of love with technology seems to still be in place even as economic recovery remains anticipated. And, while we agree that the capex rebound will not be robust as it has been in the past, we believe that is the consensus opinion already. Hence, any upside surprise will be rewarded. As such, we think we are well-positioned with our more bullish posture on the semiconductor stocks. What To Look For When Timing The Market? Sentiment shifts are likely to be the biggest factor in timing the market since we have seen optimism on the war effort recently spark a 1,000-point rally on the Dow Jones Industrial Average and then concerns about a bogging down cause a market correction. Now the view is that earnings will be disappointing given excessive 2H03 EPS estimates from sell-side analysts. We assess sentiment using our Other PE index which has been a good indicator for subsequent market performance 12 months later. The Other PE scores were in "panic" territory from the end of May 2002 until the end of October 2002 (Figure 4) with the S&P 500 trading between 800 and 900 at the time. Given 20%-25% gains in the past a year after the score was in deep panic mode (see 1994-97), we are encouraged about the extension of the current trading rally into the summer. Figure 4: Source: Smith Barney Institutional Equity Strategy In addition, as we noted in last week's Musings, the earnings outlook seems far from bleak with uneven but upwardly trending earnings growth expectations. In our opinion, it may be worthwhile to watch semiconductor prices for some guidance as to broader earnings trends. Geopolitics also seem worth a look since the equity risk premium has climbed in reaction to the military campaign in Iraq, the oil supply issues from various countries outside the Middle East, terrorism fears and North Korean nuclear ambitions. In the past two weeks, we have seen the Iraqi battlefield calm down, the North Koreans hint at willingness to hold multilateral (rather than direct U.S.) talks and there have even been some signs of some progress on the Palestinian-Israeli conflict (although there has been heightened rhetoric about Syria). Thus, we may see some subsiding of the equity risk premium as it catches up to the better trend in high yield bond spreads. In this vein, we continue to think that investors should be buyers of financial stocks (primarily capital markets and credit sensitive areas including brokers, diversified financials and insurance) as well as some underperforming consumer areas (such as hotels, leisure and media) in addition to semiconductor and semi equipment names. Note that given the likelihood for relatively low annual appreciation from stocks (versus the 1980's and 1990's), more attention will have to be placed on dividends -- a theme we have been promoting since last September. And a low dividend payout ratio compared with the past 40 years (Figure 5) supports the argument that the dividend thesis is far from over despite the impressions that might be left by proponents of the President's dividend tax policy. In essence, dividends always have been critical to stock returns irrespective of tax policy (and should grow in importance as they have in the past couple of years). We would stress that a dividend focus does not mean chasing high dividend yield stocks since dividends can be trimmed. Strong free cash flow generators tend to have the greatest prospect for growing or initiating dividends as noted in "Monday Morning Musings: Dissecting the Dividend Divide" on November 15, 2002. Thus, one can enhance their longer-term returns as well as the shorter-term "timing" methodology. Figure 5: Source: Smith Barney Institutional Equity Strategy -------------------------------------------------------------------------------- ANALYST CERTIFICATION APPENDIX A-1 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 Citigroup Global Markets Inc. 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. Smith Barney Equity Research Ratings Distribution Data current as of 31 March 2003 Outperform/ In-line/ Underperform/ Buy Hold Sell Smith Barney Global Equity Research Coverage 34% 41% 25% (2576) % of companies in each rating category that 47% 42% 37% are investment banking clients As noted in the headings to our ratings-distribution table, for purposes of NASD/NYSE disclosure rules Smith Barney's 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: Smith Barney's 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. Risk ratings for Asia Pacific are determined by a quantitative screen which classifies stocks into four risk categories: Low Risk, Medium Risk, High Risk, and Speculative Risk. 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. OTHER DISCLOSURES In addition to Investment Banking compensation that is disclosed in the Important Disclosures section of this research report, the Firm and its affiliates, including Citigroup Inc., provide a vast array of non-investment- banking financial services, including among others corporate banking, to a large number of corporations globally. The reader should assume that the Firm or its affiliates receive compensation for those non-investment-banking 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. Securities recommended, offered, or sold by the Firm: (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 Smith Barney believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute the judgment of Smith Barney's Equity Research Department 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. 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