SB: Monday Morning Musings: Focus on Earnings Not Interest Rates 08:14am EDT 22-Apr-02 Salomon Smith Barney (Tobias M. Levkovich) SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings: Focus on Earnings Not Interest Rates
April 22, 2002 SUMMARY * Markets edge higher last week sparked by earnings Tobias M. Levkovich and economic trends * Greenspan's comfort statement last week regarding rate hike patience fails to generate investor excitement * Better-than-expected results at roughly 60% of those companies that have reported are being dismissed due to "lowered expectations" while valuations are cited as an additional concern at the same time * Fascinatingly, the equity market has climbed more times in periods of rising interest rates over the past 87 years than they have during declining rate periods * Gallup poll shows continued economic confidence amongst the American public, sustaining commentary from many non-tech corporations OPINION
(*)Tobias Levkovich holds a long position in the securities of DuPont.
(*) William Sitar holds a long position in the securities of Wells Fargo.
Last week's equity markets' performance was marked by a powerful earnings- inspired rally on Tuesday that failed to generate much follow-through as highly skeptical investors continue to worry about the sustainability of economic and profits recovery as well as geopolitical fears that manifested themselves via the tragic plane crash in Milan on Thursday and the financial institutions' terrorist threat on Friday. Moreover, statements by Alan Greenspan on Wednesday with respect to the strong likelihood that the Fed will not be quick to raise short term rates also did very little to reverse investor caution.
Interestingly, the fear of interest rate hikes is part of the reason that investors are sitting on the sidelines since there is this common perception that as rates increase, markets dip. Unfortunately, such unsupported conventional "wisdom" is often borne out as being meaningfully wrong! In a study we conducted, looking at the equity markets since 1915, we found that the stock market has climbed in 58 of those years while interest rates (as measured by the discount rate) fell in only 29 of the past 87 years. In fact, equity indices rose in only 22 of the years in which rates declined (for a 70% average) while stocks appreciated in 36 years when rates rose (a 64% average). In this context, it is almost a dead heat if stocks climb when interest rates increase or decrease. Thus, we consider the focus on the Fed and interest rates as being less important than if earnings expand.
We understand that about 60% of those companies that have reported 1Q02 results thus far have beaten Street numbers with the common refrain being that those estimates had been lowered and thus topping "lowered" expectations are not quite the same as really exceeding the "true" prior consensus. While admittedly accurate, the strange part about such a response is that part of the issue about the equity market that bears often highlight is the expensive valuation usually measured by the market's P/E ratio. Therefore, we are a bit confused by the ratio's impact if the E is artificially low due to "lowered" expectations. Either, the earnings estimate is being understated and thus the P/E ratio is not as high as some claim, or the numbers being beaten should be part of the market's upside potential! Intellectual honesty requires one or the other to be accurate and when practitioners of "circular illogic" gain the upper hand in how many perceive the equity markets, we think that potential market upside cannot be that far behind since such irrational conclusions driven by misperceptions almost certainly will be proven incorrect, in our opinion.
Some investors have pointed out that the outlook statements being put forward by companies are less than encouraging, but we would be careful in making that assessment. Technology firms that depend on capital investment cycles clearly are not bullish and recent news out of Worldcom regarding its capex trends support the argument that telecom equipment companies still have some tough times ahead. However, if one bothered to listen to companies like 3M, Wal- Mart, General Motors, Wells Fargo, DuPont, Maytag and various homebuilders, not to mention forestry products companies, the tone was definitely more upbeat. Therefore, once again, we stress that investors should not look at the overall economy through the simple technology prism.
Indeed, a recent Gallup poll (April 8-11) shows that American consumers remain optimistic about their future. In fact, in March 2002, for the first time since October 2000, more than half of those surveyed indicated that economic conditions were improving. And, that trend continued on into April. Specifically, 53% of those surveyed noting an improving economy, almost equal to March's 54% score. As a side note, consider that only 19% of Americans felt that economic conditions were improving in September 2001; before 9-11! Moreover, only 45% of Americans think the economy is now in recession, down meaningfully from 56% in March. For comparison, in the early 1990s, more than 80% of Americans thought we were in recession, with the numbers only dropping to 50% in late 1993. Accordingly, both the consuming public and many companies are suggesting that the U.S. economy has firmed. While we have stressed that investors should look at industrial production (i.e., factory sales) driven by ISM new orders data as an important earnings driver, we found it fascinating that 58% of Midwesterners surveyed thought the economy was getting better. Hence, our focus on industrial companies does seem to be showing up in the polls too.
While we have heard many investors wonder as to why we are so focused on the manufacturing economy which accounts for 15% of U.S. GDP, we have attempted to point out that it accounts for 75% of industrial production vs. only 7% from the tech sector, which itself only accounts for 4% of GDP. In many respects, we could ask why there is so much emphasis on the relatively small tech sector?
Moreover, for those that are highly concerned about valuation, we would point out that the most aggressively valued sector remains Information Technology (see Figure 1), while traditionally low P/E sectors still seem attractive to us (Financials and Utilities). To be fair, both the Consumer Discretionary and Industrials sector, which we favor, do not look cheap on their fiscal 2002 P/E ratios (based on consensus estimates) either, but we would point out that their earnings are well below trend given the recession. While the same could be said of the tech sector, we would point out that telecom reliant industries may have to wait until late 2003 for recovery while analysts still have wildly optimistic 2H02 estimates for many of the tech names, in our view. Nonetheless, given the realization by many that renewed capital investment on technology might not begin to recover until late 2002 or even early 2003, we suspect that tech trading rally could emerge by mid-year. While we think it is too early to position portfolios for that opportunity just yet, the palpable sense of tech stock capitulation is beginning to come to the fore.
Figure 1:
(Figure can only be viewed in PDF)
Source: Factset and SSB
Companies Mentioned:
(*)Tobias Levkovich holds a long position in the securities of DuPont.
(*) William Sitar holds a long position in the securities of Wells Fargo.
DuPont# (*) (DD-47.36; 2M)
General Motors# (GM-$65.63; 2M)
Maytag# (MYG-$45.13; 2H)
Minnesota Mining & Manufacturing# (MMM-$124.89; 2H)
Wal-Mart# (WMT-58.93; 1L)
Wells Fargo# (*) (WFC-51.09; 1L)
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