SB: Monday Morning Musings - Unscrambling the Valuation Puzzle

07:02am EST  4-Mar-02 Salomon Smith Barney (Tobias M. Levkovich)

SALOMON SMITH BARNEY                                             Industry Note

 

Institutional Equity Strategy

Monday Morning Musings - Unscrambling the Valuation Puzzle

 

March 4, 2002             SUMMARY

                          * As we see it, many people mistakenly believe that

Tobias M. Levkovich         the market P/E is too high relative to history.

                          * Low inflation is one buoy to higher P/E's and we

                            would also remind investors that median multiples

                            are not outlandish.

                          * The valuation dichotomy within the S&P 500

                            becomes very apparent when looking at the P/E's of

                            the ten major sectors and by breaking the S&P 500

                            into quintiles.

                          * ISM new orders was at its highest level since

                            1994 and was the third month in a row above 50.

                          * We can see the grounds for a continued market

                            rally led by the Industrials, Financials and

                            Consumer Discretionary sectors.

OPINION

 

We believe many professional money managers and individual investors have been

suffering from a common misconception of late.  In fact, we believe that it has

led to delusional views regarding the equity market and has caused errors in

judgment.  In particular, we see a general misunderstanding of the stock

market's valuation levels as numerous members of the investment community

presume that the market P/E is too high based on historical context.

 

Specifically, when reviewing historical market P/E ratios (Figure 1), one can

see that the S&P 500 is trading well above its past 10-, 20- or 30-year

averages.  Moreover, even after the market's correction from highs experienced

in early 2000, the S&P 500 is still trading at roughly 23x anticipated 2002 EPS

estimates, well above the 7x multiple at the trough of the market in 1974 and

13x following the 1987 market crash.  Therefore, it is easy to conclude that

these exceptionally high P/Es cannot last and that the market will pull back or

that earnings climb alongside production increases this year but there is no

commensurate equity market appreciation, thereby causing P/E multiple

contraction.

 

The Market Is More Reasonably Priced Than It First Appears

 

First impressions, while often lasting, can also be misleading.  In our

opinion, that seems to be the case when one reviews the equity market's P/E

ratio.  At first glance, the market appears to be richly valued, but one must

better understand the underlying inflation environment.  As can be seen in

Figure 2, the market's P/E is related to inflation rates.  And when we attempt

to remove the tech bubble's impact on the market's P/E by using median P/E

ratios (Figure3), we find a similar relationship.  Thus, at 12% inflation

rates, a 7x multiple in 1974 is not unreasonable while 4% inflation might yield

a 13x multiple as was the case in 1987.  But when assessing an anticipated

inflation rate below 2% (based on the current 1.7% spread between the nominal

yield on 10-year Treasury notes and the inflation indexed TIPS yield), a 23x

multiple is quite rational.  Moreover, when looking at the market's median

multiple of 19.5x estimated 2002 earnings, stocks appear fairly reasonably

priced.

 

In fact, if one looks at the various sectors within the S&P 500 (Figure 4), the

weighted valuation dichotomy becomes even more apparent given the sky high P/E

ratio found in the Information Technology sector which commands a more than 40x

ratio.  Thus, if just the tech stocks' P/Es contracted, the overall market's

multiple would come down.  Hence, if we are worried about excessive valuation,

one has to understand where that discrepancy lies.

 

Furthermore, if one dissects the companies within the S&P 500 into quintiles,

it is clear that the top quintile trades at the high multiples (Figure 5) while

the next 400 names do not.  Accordingly, as the old adage goes, "never judge a

book by its cover!"  But before, one jumps to the simplistic conclusion that

the weighting of the market P/E is just a market capitalization issue, we would

emphasize that the arbitrage that existed last year between large cap stocks'

multiples and small caps has closed markedly (Figure 6) with small caps more

highly valued today than the S&P 500.

 

To be candid, using a P/E valuation metric alone is not always appropriate, but

we do think that the above discussion is important in separating conventional

wisdom or market perception vs. fundamental reality.  As we have discussed on

various occasions in the past, informed investors have the opportunity to make

money exploiting the gap between unfounded perception and underlying reality,

and we consider the high P/E argument to fall into that category.

 

The Earnings Yield Gap Remains Attractive

 

In early April and late September 2001, we argued that investors should buy

stocks based heavily on vacillating investor sentiment and highly attractive

valuation when looking at the earnings yield gap (Figure 7).  In fact, at more

than two standard deviations below its five-year mean, we had a fair degree of

confidence at those times that equities would outperform debt instruments.

Now, at only one standard deviation below the mean, stocks are attractive but

not as much as they were in those previous periods.  But, as we have tried to

argue for the past couple of weeks, we believe that earnings visibility is

improving alongside indications of economic expansion and rising orders.

Therefore, when we juxtapose earnings growth expectations and continued

investor skepticism (in view of accounting concerns and the losses following

the dot-bombs), we can see the grounds for another market rally. Indeed, the

economic conditions improvement is not just a domestic event, with Germany

(Europe's largest economy) and France experiencing their fourth month in a row

of growing business confidence.

 

Note that the ISM new orders index at 62.8 was at its highest level since 1994

and was the third month in a row above 50, highlighting expansion.  We believe

investors will begin to hear more confirmation of this industrial trend from

more companies in the next few weeks, which may drive the market even higher.

Thus, we do not view Friday's rally to have been the main event.  Investors

have been seeking orders data to get earnings visibility and they got an eyeful

with the ISM.

 

Consequently, we believe that the equity markets have further appreciation

potential led by the Industrial, Financials and Consumer Discretionary sectors.

As cyclical conditions continue to improve, we think that stock prices can

climb roughly 20% in the next few months and we would not be deterred by

unsupported valuation contentions.  Hence, we are maintaining our S&P 500

upside target of 1300-1350 this year.

 

Finally, we would point out that while we expect tech stocks to participate, at

least near term, in any equity market gains, we strongly doubt that it will be

the market leader it once was.  In addition, cyclical conditions do not favor

defensive sectors such as Health Care and Consumer Staples given relative

earning growth.  Thus, we are retaining our Slight Underweight posture on these

two areas.