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Monday Morning Musings - Four Questions (Part 1 of 2)
Analyst: Tobias M. Levkovich
SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings - Four Questions
March 25, 2002 SUMMARY * We answer the top four questions we have been Tobias M. Levkovich hearing from clients * Not surprisingly, rising interest rates' impact on valuation, earnings, capital investment and consumer spending issues are foremost on investors' minds * Stocks generally climb after rates increase post economic troughs if earnings grow * The next uspide catalyst is likely to be during the earnings period when estimates possibly get beaten and 2Q02 guidance gets raised OPINION
In the past two weeks, we have been visiting with institutional accounts and have come face-to-face with four key questions that appear to be plaguing professional money managers and have prevented the markets from going higher. While we have attempted to address these issues on a one-on-one basis, we also fully recognize that we cannot do that in a timely, efficient manner; hence, today's musings. While we have addressed these topics in previous write-ups, we have decided to address them head on in a singular piece.
The critical questions have been:
* How can profits grow reasonably in a period of no or low inflation when productivity benefits appear to accrue to consumers and not corporations, especially if the "recovery" is simply a short-term inventory rebuild story?
* How can consumers continue to spend this way in view of rising energy prices and high debt levels?
* How can corporate capital spending increase meaningfully if capacity utilization is so low, thereby curtailing any real extended recovery mode?
* If interest rates rise, doesn't the stock market have to pull back given current valuation levels? Put another way, isn't economic recovery priced into the equity markets already?
To be fair, these questions are interrelated to an extent, but we will address them in the order presented above.
1. The Case For Reasonable Profit Growth
For the past nine months (since mid-August), we have presented Figure 1 in an attempt to educate investors as to what has driven earnings almost every single time over the past 30-odd years -- industrial production! Moreover, since the manufacturing economy accounts for roughly 75% of industrial activity (vs. only about 7% of domestic production coming from the much ballyhooed tech sector), the depressed inventory levels and production rates relative to final demand must be examined thoroughly. As can be seen in Figure 2, production is running at 97% of final demand currently and that was seen back in the early 1980s with a very substantial bounce in 1984 that drove earnings well above our current projections for 2002 and 2003 EPS combined. We do not think that such a powerful rise in production will occur this time (due to a lack of consumer pent up demand), but a substantive pick-up is likely and recent economic data suggests that it already has begun in January. The key thing to remember is that this is how recovery in production (and related employment) has occurred in every period that we have looked at in the past 32 years! Thus, we are not banking on some new and unproven experiential thought process to evolve, but rather a time-tested reliance on a recurrence of past trends that have no specific reason to disappoint us this time around.
Figure 1
Source: DRI and SSB
Figure 2
Source: SSB
While the end of inventory de-stocking is part and parcel of our anticipated production recovery story for 2002, we would note that it always has been a crucial factor in starting up recovery once consumers had depleted the inventory stores within the economy. Thus, this "short-term" inventory concern is what has generally stretched out economic recovery once consumers were re- invigorated via (primarily) lower interest rates to consume again. Accordingly, production upticks are simply stage two in recovery mode after the consumers begin to lead us out as they have by scooping up homes and cars at a relatively fast pace. And, as far as the productivity benefits go, high productivity means that companies can pay workers more (in wages) and still have lower per unit labor costs, but the greatest profit variances come from overhead cost absorption trends and that is thoroughly related to volumes produced overall, not per man-hour. This profits driver has little to do with inflation since many industrial sectors have had low or no pricing power for as much as two decades but still have generated enormous profit leverage coming out of recessions until the next economic peak. Hence, history is very much on the side of the bulls.
2. Isn't The Consumer Tapped Out?
For the past 15 months, the investment community has been barraged by the threat of consumer failure with bears citing high debt levels, stock market losses, low savings rates and job losses, only to be surprised by shoppers' resilience. A housing bubble was then blamed (in late 2001) and that did not work either, although we suspect that concerns about rising interest rates may revive this story soon. Now the rising cost of oil (tied to a growing war premium given Iraq-related saber-rattling) and its impact on gasoline prices at the pump will be discussed. Yet, oil prices are down 20% year over year and will only end higher in late September (year over year) if they stay in the $25/barrel area. At the same time, natural gas prices and electricity prices are down substantially as well. Consequently, we doubt that recent pump price increases will "break" the consumer, especially as employment growth resumes alongside production recovery as it always has (Figure 2). Investors need to recall that the manufacturing economy dropped 1.3 million jobs in the past 15- 18 months as production collapsed last year to clean up inventory -- this should turn around as production lifts. Interestingly, for some unknown reason, many bears see one-time, nonrecurring benefits from lower energy costs and interest rates in 2001 and 2002 but assume that unemployment hits are recurring despite a long-term history of job creation in the U.S..
Figure 3
Source: DRI
3. Capital Spending Is Driven By Profits, NOT Utilization Levels
As we pointed out in our article in this past week's Portfolio Strategist, capital investment has begun to climb at various levels of capacity utilization in the past 20 years (Figure 4), suggesting that there is no magic number at which new spending is triggered. Moreover, as Figure 5 indicates, the driver has been a recovery of corporate profits, which provides the wherewithal to spend again, thus extending the cycle. As a reminder, the consumer first pulls down inventories by purchasing goods; production then kicks in and drives earnings higher (about two quarters after GDP bounces back) and those earnings then generate new capital investment (also with a roughly two-quarter lag). In many cases, spending is cost-oriented not increased capacity related. For example, we have heard from engineering contractors that semiconductor companies indeed are planning to go ahead with 300mm and sub-0.15 micron technology fab investments now after almost a full year hiatus in spending intentions -- the driver for such investments is to lower costs by improving yield throughput by as much as 30%-40%. While new capacity is generated, the real benefit to the chipmakers is reduced cost that can generate both incremental sales and higher margin potential. In addition, we can imagine similar benefits in other industries where cost efficiencies propel new investment.
Figure 4
Total Capital Spending (Year Over Year Absolute Dollar Changes) versus Total Capacity Utilization)
Source: DRI
Figure 5
Source: DRI and SSB
4. Stocks Can and Do Rise In Higher Rate Environments ... Early On.
As one can determine from the data provided below in Figure 6, stocks can and generally do climb, for the most part, after the Fed lifts interest rates coming out of an economic trough. We have gone back 50 years and looked at discount rate increases post-economic lows and found that, in only one instance (1980) did the market falter, but that was due to the back-to-back downturns in that time which was unique given the inflation conditions prevalent at the time and Paul Volcker's inflation fighting tactics. Moreover, if one looks at the S&P 500's price gains in the other periods, we can determine that the bulk of every gain was driven by earnings growth, with multiple compression occurring in the three periods since 1980. Consequently, we may very well need to experience multiple compression in the next 12 months, but earnings growth in the double digits in 2H02 and 1H03 suggests that we can achieve our target of 1300-1350 on the S&P 500 this year.
Figure 6
Source: SSB
Catalysts For Change
We continue to believe that the next driver for a stock market upsurge will be earnings and guidance in the next few weeks for 1Q02 and 2Q02. In general, we expect many traditional industrial companies to either beat 1Q02 expectations or guide 2Q02 higher given improved order trends. While this week may be restrained by the focus on the Passover and Easter holidays, that may change markedly in the first week of April and the condition should last into early May. As a result, we retain our positive view of the equity markets and think another up leg is coming soon. Hence, we would be positioned in industrial companies, auto components, financials and media names.
------------------------------------- Monday Morning Musings - Four Questions (Part 2 of 2)
Analyst: Tobias M. Levkovich
Securities recommended, offered, or sold by SSB: (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested.
Mar-25-2002 11:34 GMT |
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