Monday Morning Musings: Is There More in 2004?

Analyst: Tobias M. Levkovich

Smith Barney

Equity Strategy                                                                

Monday Morning Musings: Is There More in 2004?  

September 8, 2003              SUMMARY                                         

* We continue to believe that the equity         

Tobias M. Levkovich              markets will rally into year-end with a       

possible overshoot of our 2003 target of 1,075

for the S&P 500.                              

Evrard Fraise                  * However, we are introducing our 2004 price    

targets of 1,025 for the S&P 500 and 9,750 for

the Dow Jones Industrial Average; a view      

               consistent with our Trading Places thesis.    

* While sentiment gauges are still modestly     

positive for 2003, risks in 2004 do exist.    

   * The marginal rate of change to forward        

earnings projections is approaching the higher

end of its historical range.                  

* Valuation has gone nearly neutral on our      

metrics.                                        

OPINION

See PDF version of this document on GEO or FC Linx to view all referenced

figures.

As we pointed out in our September 4, Portfolio Strategist ("Fourth and Goal"),

we continue to believe that our year-end 2003 target price of 1,075 for the S&P

500 is not only achievable but also can be exceeded.  History is on the bulls'

side, since late-year stock price performance is typically quite good.  In

addition, capital spending trends, earnings from industrial companies, asset

class shifts, economic prospects and investor psychology could provide a

favorable equity market investment climate over the next three-to-six months.

However, we remain convinced that the market has entered a trading period rather

than a new bull market, as outlined in our Trading Places report series first

published in December 2001.  Furthermore, we have been pointing out for some

time that the stock generates widely variable returns from year to year, with

very few periods of sustained annual gains as seen in the bull market run of the

latter 1990's (see Figure 1).  Hence, we do not believe that investors should

expect further market gains in 2004, as the market is likely to be range bound,

trading down modestly by the end of next year.  In this vein, we are introducing

formal year-end targets of 1,025 for the S&P 500 and 9,750 for the Dow Jones

Industrial Average, which compare to our year-end 2003 objectives of 1,075 and

10,375, respectively.

Figure 1:

Source: Global Financial Database and Smith Barney

While our year-end 2004 targets appear pessimistic, we do think that current

equity market strength could continue into early 2004, particularly in more

cyclical sectors, before economic and sentiment concerns combine to possibly

restrict further gains.  Specifically, the economic boost from the 2003

individual income tax cuts will exhaust themselves by mid-year 2004 and our

proprietary Other PE's "euphoria" readings this summer (Figure 2) should have an

impact by mid 2004.

Figure 2:

Source:  Smith Barney Equity Strategy

How Do We Derive Our Targets?

We have repeatedly stressed that we have been tactical (rather than strategic)

bulls on equities and thus we are keeping to our disciplines and are not

abandoning stocks.  But, we are not perma-bulls either, without having any sense

of valuation and earnings expectations built into our analytical framework.

Hence, while some may perceive our 2004 perspective as being downright bearish,

we would note that our outlook into the early part of 2004 remains quite

optimistic about stock market returns.  Nevertheless, given our consistent

trading view of the market, one may have to be opportunistic and practice more

dynamic portfolio dexterity vs. the 1982-99 bull market environment when the

"buy and hold" mantra dominated.  Bear in mind that our view does not preclude

an equity market overshoot (beyond our 2003 targets), driven by retail investors

who have a tendency to chase performance or portfolio managers who may attempt

to "swing for the fences" later this year, but we would look to any such

unjustified moves as potential exit points.

Having said that, we use a number of valuation disciplines to derive our year-

end targets.  In mid-2002, we adopted the price-to-book methodology during the

"crisis of confidence" on earnings quality, but given that reported and

operating EPS are now more in line (see Figure 3), we are reverting back to more

traditional P/E metrics including:

*   Earnings yield gap

*   Debt-Adjusted Valuation

*   Implied long-term U.S. earnings growth

*   Our S&P 500 "Forecaster"

Figure 3:

Source: Smith Barney

The first tool we use to get a sense of market valuation is our earnings yield

gap analysis.  This model compares the earnings yield of the market (inverse

P/E) to the yield of a 10-year Treasury.  It is a derivation of the so-called

"Fed Model", except that we prefer to look at the gap between the yields versus

a rolling five year average as opposed to the gap in a vacuum.   Specifically,

the distance the gap is from the mean (measured in standard deviations) has

proven to be a reliable market-timing indicator in the past when it reaches

extreme conditions.   Currently, the gap has narrowed significantly in recent

weeks and is now less than one standard deviation below the mean (see Figure 4).

This has caused us to be less enthusiastic about the attractiveness of equities,

but by no means suggests that current equity market appreciation is over.

However, if bond yield were to increase to 5%, which is what our economists are

forecasting for 2004, and the S&P 500 reached our target of 1,075, the model

would be roughly 0.4 standard deviations below the mean which would mute the

valuation argument.

Figure 4:

Source: Smith Barney

Another tool we use in valuing the market is our proprietary (patent pending)

debt-adjusted valuation metric.  This methodology captures both the cost of debt

and equity against corporate capital structures and has been very adept at

indicating attractive equity entry points in the past as well as exit points.

In fact, we can go back over the past fifteen years (see Figure 5) and show that

the equity market looked attractive in both the 1989-91 and 1994-96 periods.

Moreover, the indicator bottomed in February 2003, which proved to be an

opportune time to buy stocks.  Currently, the indicator is still attractive, but

has been coming off the lows seen earlier this year, but we would note that with

the S&P 500 approaching our year-end target of 1,075, the indicator would no

longer be in attractive territory.

Figure 5:

Source: Smith Barney

We would point out that our implied long-term earnings growth model (Figure 6)

now shows a neutral valuation with implied long-term EPS nearing 6%, which is at

the high end of our 5%-6% view.  Hence, the market seems to be in the process of

beginning to discount earnings prospects into the future.

Figure 6:

Source:  Smith Barney Equity Strategy

The "forecaster" (as seen in Figure 7) is a simple tool that encompasses current

and future expectations of bond yields and S&P 500 P/Es to derive a target level

for the S&P 500.  The outlook for 5% yields on 10-year Treasuries and 9%-13% EPS

growth would imply a 1,000-1,050 type level on the S&P 500.

Figure 7:

Source: Smith Barney

Furthermore, should the market move back to its average P/E level of the past 40

years by year-end 2004, one could arrive at a 1,025 target, when assessing 2005

consensus S&P 500 EPS estimates in the $66 area.  Our Dow target of 9,750

represents a 9.51x multiple to our S&P 500 target, which has been the average

historical ratio of the Dow Jones Industrial average to the price of the S&P 500

index (see Figure 8).

Figure 8:

Source: Smith Barney

What Could Cause Us to Be Wrong?

There are two big risks to our more cautious 2004 view:

*   Earnings could continue to "blow through" expectations and thus act as

the propellant for robust market appreciation, driven by a powerful capex

rebound and the resilient U.S. consumer, not to mention synchronized

global recovery.

*   The global liquidity push (via money supply growth) is sustained

indefinitely.  However, both fed funds futures and Eurodollar futures

suggest that this is unlikely.

On the other hand, there are two reasonable scenarios that could disrupt a more

buoyant 2004 equity market outlook.  In the first instance, stronger economic

growth will remove the deflation threat and reinstate inflation concerns,

thereby driving up bond yields, exerting P/E multiple contraction pressures on

the market.  Under the second scenario, if earnings fail to come through next

year (for unanticipated reasons), this may cause the equity markets to correct.

Moreover, neither of these outcomes assumes any exogenous shocks (e.g.,

unanticipated oil price spikes, war, terrorism, etc.).

We would remind investors that when stocks are caught in a trading range,

rallies are followed by pullbacks, meaning that investors need to practice what

we think of as "portfolio dexterity" --- a willingness to take profits when

appropriate, and the use of positioning tactics when thinking about sector and

industry group selection.  As a result, as we get into 2004, a move away from

high beta areas (i.e., Information Technology, Financials, and Capital Goods)

and into more defensive industries (i.e., Consumer Staples, Health Care

Equipment and Services, Real Estate, and Energy) may be appropriate.

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