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) |
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