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

 

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Mar-25-2002 11:34 GMT