SB: Monday Morning Musings: Mirror Images

06:15pm EDT 12-May-02 Salomon Smith Barney (Tobias M. Levkovich)

SALOMON SMITH BARNEY                                             Industry Note

 

Institutional Equity Strategy

Monday Morning Musings: Mirror Images

 

May 12, 2002              SUMMARY

                          * Sentiment is awful currently despite improving

Tobias M. Levkovich       fundamentals

                          * Sentiment was awesome at the peak of the tech

                            bubble while fundamentals were wanting

                          * The inventory correction was startling in 2001

                            relative to past recessions, crushing earnings

                          * That should begin to reverse very shortly and

                            cause the earnings driver to push up stocks

                          * However, bondholders now do not seem to understand

                          the risks they are taking

OPINION

 

(*) An immediate family member of Tobias Levkovich holds a long position in the

securities of Intel.

 

It Looks Very Much The Same But Entirely Opposite

 

If one could roll back the clock roughly two years, one would be in a very

different stock market environment.  The scenario would involve unbridled

optimism in the New Economy, very low risk concerns and, to a great extent,

lacking fundamentals beyond such new metrics as "eyeballs", "momentum-driven"

valuation, first-mover advantage and "mindshare."  Indeed, the extraordinary

Information Technology sector focus back then could have been deemed

appropriate since it accounted for roughly 25% of GDP growth at that time.

However, the factor that seemed to finally break that bullish psychology was

the inability to achieve the ever-increasing earnings estimates, as some stocks

got slammed when "whisper" numbers were missed, even though official estimates

were trumped.  Thus, in a certain respect, investor sentiment at times may take

over one's better sense.

 

In an almost mirror image, we believe that we are looking at a similar kind of

environment currently, with fundamentals improving and investors unwilling to

believe, being very risk averse, and continuing to look at the world through a

very narrow tech-inspired prism.  To a certain degree, the news out of Cisco

Systems last week only confirmed the investment community's fascination with

the sector once again, with not just Cisco and its peers rallying, but also the

whole market.  Unfortunately, to get the complete mirror image going, we will

need earnings, which we envision coming from a needed inventory restocking

phase that could last a few quarters and then lead us to some cyclical capital

investment rebound.

 

As one can see in Figure 1 below, the 2001 inventory correction (and related

production declines) were the worst we have experienced in more than two

decades, with this downturn being far more meaningful than the 1979-80 and

1981-82 recessions' impact, a period that was considered quite severe.  In

addition, the 1990-91 downturn from a production perspective was quite mild,

but the 2001 plunge caused a massive earnings hit.  As we pointed out in last

week's Musings, the semiconductor industry suffered a roughly $15 billion

decline in income from 2000 to 2001 which related to meaningful under-

absorption of high fixed overhead costs (deprecation charges related to $2

billion fabs) and the tone at last week's Salomon Smith Barney Semiconductor

Conference was clearly more upbeat (excluding PC-related chips), which should

help the earnings outlook as well.  As a reminder, we favor the semiconductor

names within the IT sector which remains market weight.  In this context, we

continue to like names like Analog Devices and Intel.

 

Figure 1

 

Source: SSB

 

Moreover, we continue to like the most production leveraged names including

auto and auto component players (Ford, Borg Warner and Magna International) as

well as those suppliers that should benefit from higher auto build rates

including aluminum and steel producers such as Alcoa and Nucor, respectively.

Moreover, the farm bill should benefit Deere & Company.

 

As production climbs so should earnings if history is any guide and thus we

most probably will see some capex recovery late in 2002 as businesses begin

some cautious cyclical upgrades.  Capital investment generally lags profits by

two quarters and there may be some pent up demand that must be satisfied.

Thus, given the likelihood of earnings recovery and the early indications of

capital spending recovery, we think a summer rally is likely (unlike our

feelings last year).  Note that according to the Information Technology

Association of America, employers will need to hire about 1.1 million new IT

workers this year, up from 900,000 workers last year, suggesting that some IT-

related capex might have to go along with these new hires.  Bear in mind that

the survey, conducted in 1Q01, included 155 IT companies and 377 non-tech

firms.

 

Are Bonds Safe Relative To Equities?

 

While we have argued that stocks are the better choice than bonds currently, we

would point out some fascinating results of a recent Harris poll especially

since we have seen substantially better inflows to bond mutual funds in the

past year as investors have looked to lower their exposure to stocks (Figure

2).  The Harris survey conducted with more than 2,700 investors found that

while 65% of those polled expected interest rates to climb, a shocking 70% did

not realize that the rate hikes would hurt the value of their bond funds.

Thus, it would seem that pessimism over equities are overwhelming common sense

again and some very basic research.  In a rising rate environment, equities

could face some multiple compression but it usually occurs when the economy

(and earnings) improve.  Accordingly, stocks can benefit from earnings growth

while "safe" Treasury or agency bonds simply cannot.

 

Figure 2

 

Source: ICI

 

Technology's "Mindshare" On The Street

 

As we have noted in the past, the technology industry accounts for less than 4%

of GDP, 3% of U.S. employment and only 7% of industrial production, but

accounts for almost 50% of S&P 500 trading volume (in fact, our most recent

study showed 49% in 2001).  Yet, to be fair, as seen in Figure 3, the

Information Technology sector accounts for about 15% of the S&P 500's market

capitalization and roughly 8% of sales, while the Consumer Discretionary sector

comprises almost 22% of sales and less than 14% of the S&P 500's market cap.

Hence, the IT trading volumes still seem outlandish relative to 8% of sales

contribution but somewhat less so than 4% of GDP.

 

Figure 3

 

Source: SSB and Factset

 

Companies Mentioned

 

(*) An immediate family member of Tobias Levkovich holds a long position in the

securities of Intel.

 

Alcoa Inc.# (AA-$34.90; 1M)

 

Analog Devices, Inc. (ADI-$36.85; 1H)

 

Cisco Systems Inc (CSCO-$15.75; 1H)

 

Deere & Company# (DE-$43.60; 1H)

 

Intel Corporation (*) (INTC-$28.24; 1M)

 

Nucor Corporation (NUE-$58.73; 1M)