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)