SB: Monday Morning Musings - Can the CEO Always See and Know? 05:56pm EST 8-Mar-02 Salomon Smith Barney (Tobias M. Levkovich) SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings - Can the CEO Always See and Know?
March 8, 2002 SUMMARY * Business Council survey shows that 75% of CEOs Tobias M. Levkovich still think we're stuck in recession * Greenspan, economists and the bond market think * The data are shifting rapidly making quick confirmation difficult * Public company CEOs have greater constraints than private ones * National Federation of Independent Business survey in January was more bullish * It is hard to dispute the ISM and employment news * This speed factor does play into stocks and sector rotation * Initial rate increases do not mean the end of an equity market rally OPINION
The seeming contradiction between the plethora of continued positive economic data and still cautious corporate guidance remains a difficult hurdle for many investors to fully comprehend, but may simply be another reflection of a rapidly changing economy where macro information flows occur very quickly and it takes some time to see where the micro trends lay. In addition, while final demand may not yet be rising, the sharp cutbacks in industrial production- related industries, has curtailed inventories so massively in the past year that the news of improvement is more of a production-driven phenomenon. Moreover, many investors have been looking to the tech sector for leadership out of this downturn despite the fact that it was the manufacturing economy that took most of the hits. Once again, we feel a need to point out that GDP usually turns two quarters before corporate earnings do (using the S&P 500 as our proxy for corporate EPS) and then it takes another two quarters for capital spending to begin recovery (and IT is part of the lagging cyclical rebound). Thus, for the most part, we believe it would be very unlikely to see a lead indication from an industry that usually lags recovery. However, after the past five years, investors have maintained their imaginations of tech being the ultimate savior despite the ramifications of the dot-bomb. Thus, when CEOs of leading tech companies are cautious, many assume that trend for the general U.S. economy, which is 96% non-tech.
Are Business Leaders' Views Lagging The Economic Data?
While it is true that a late February Business Council survey showed that 75% of CEOs still believed that the economy was mired in recession, investors appeared to hear what they wanted to hear, since they ignored the January National Federation of Independent Business survey, which suggested that small business was looking to lift production and hire again -- something that does appear to be borne out by the latest employment numbers. Moreover, in view of Reg FD, the Enron aftermath and the increasing popularity of often frivolous shareholder lawsuits to find recourse for investment mistakes, public company management teams have been extraordinarily reluctant to provide new guidance until they have meaningful data points to change their stated views. Hence, if the economy were to show rapid improve over a five-to-six week period, it is very plausible that CEO's would want to see eight weeks of solid information to buy in enough to go public with it Additionally, the front line sale staff is also reluctant to inform the corner offices immediately of a turn given the potential for false dawns. In that instance, there is a major disincentive to disappoint the higher-ups and also an incentive to hold down bonus bogies that can be more easily achieved. Thus, private small company CEOs (such as those found within the NFIB) would more naturally be more willing to commit publicly to an improving scenario, especially since they tend to be much closer to the actual daily sales trends. Keep in mind that small businessmen generally have very flat management structures and are closer to the customer than most large, vertical organization that are comprised of many different hierarchies.
While we suspect that some skeptics will continue to argue against the economy's strength, we also believe that consensus has shifted to believing in recovery now based on Fed chairman Greenspan's comments and the bond market's reaction. Indeed, we think that it is very difficult to argue with job creation and three months in arrow of improved ISM new order indices and non- manufacturing ISM improvement as well. Even some capex survey shows some promise for the latter half of the year, which is now only three-to-four months away. Plus, the scaled down stimulus bill does have an accelerated depreciation bonus built in to generate some additional capital investment push. The bigger issue for equity investors is -- have the markets already discounted the good news in its latest rally?
Three Reasons Why We Think The Market Has More "Juice" Ahead Of It.
* In our conversations with investors over the past few weeks, we have seen the consensus shift towards the "priced in" view. The powerful swing in the market over the past week or so has convinced many investors that they have missed the boat and some value investors are pulling back and taking profits. In this sense, we see the market to be at a similar point to where it was in late October 2001, when the markets rebounded partially from the September lows and no one really believed that it could continue. The degree of skepticism is quite high today as it was then. However, news of stimulus, consumer spending resilience and military success all contributed to punch the market higher in the next month. In our opinion, the news that will drive the market higher in the next month or two will be the public company confirmation that things are improving and our belief that 1Q02 earnings reports will come in better than currently anticipated. In a very important way, employment growth alone should help restore confidence in consumer spending activity being unlikely to crater as some have projected.
* Valuations still appear reasonable as we discussed in last week's Monday Morning Musings, based on current inflation expectations. While the Fed could lift short -term rates later this year, the steep yield curve and the long bond have moved to adjust for the better economic outlook. But, as we have noted before, stock prices can rise when earnings growth kicks in even as the Fed tightens. The earnings yield gap (see Figure 1on the following page) shows that this was the case in previous recovery periods (in 1990-92 when we crossed above the mean yield gap and once again in 1996-98).
* Stocks can rise even as the Fed begins to lift rates. Figure 2 provides a history of what happened after the Fed lifted rates the first time, with more positive trends in the market's behavior than negative ones. Indeed, the meaningful negative reactions were often event-driven, with the post-1968 period being the fall of the Nifty Fifties, the post 1973 period being rampant inflation and a resigning U.S. President, while the 1987-drop was due to the crash that year. In addition, we would stress that a rate increase in the early stages of recovery with significant earnings growth still to come is not the same as a rate increase later on in a cycle. In this sense we think it is premature to worry about an increases in a low inflation environment.
* Moreover the current Fed Funds rate is still very much below the average rate seen in the past few years and, thus, even if the Fed did move in late 3Q02 or 4Q02, borrowing costs would still be quite low relative to recent history. Accordingly, in contrast to those who remarkably are fighting this rally, we remain bullish.
Mar-08-2002 22:57 GMT |
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