AY:
Monday Morning Musings: Why
Have Equities Been So Vulnerable? (Part 1 of 2)
06:53am
EST 11-Feb-02 Salomon Smith Barney Intl
(Tobias M. Levkovich +x-xxx-xx
SALOMON
SMITH BARNEY Industry Note
Institutional
Equity Strategy
Monday
Morning Musings: Why
Have Equities Been So Vulnerable?
February
11, 2002 SUMMARY
* Transition mode from
liquidity to earnings is
Tobias
M. Levkovich never
seamless allowing for accounting "poison"
+1-212-xxx-xxxx darts.
tobias.levkovich@xxxx.xxx
* A few bad apples should not taint the overall
integrity of Corporate
America.
* Four reasons to believe
in reported earnings
credibility.
* The gap between liquidity
and earnings should
close in a month
or two as order trends signal an
upturn in industrial
production.
* The markets have
done well historically following
the end of an easing
cycle and we would highlight
the Consumer Discretionary
and Financial sectors.
* Current more bearish sentiment is beginning to
be
reflected in stock
prices.
OPINION
In
the last few weeks, the equity markets have come under attack,
initially
from
weak first quarter 2002 outlook statements, in our opinion, and,
most
recently,
from unsubstantiated suspicions about over-arching accounting
irregularities
across Corporate America. While
we would not defend the
practices
of a few companies that have stretched the rules and may even
have
committed
fraud, we think it foolhardy to indict the entire U.S. financial
and
accounting
systems given the actions of some bad apples.
Nonetheless, the
backdrop
begs the question as to why the markets are so vulnerable to such
attack?
The
simplistic answer would be to recognize the sizeable gains registered
since
the
September 21st lows and assume that we were due for a pullback. However,
we
believe that the reason may have a deeper root cause. As we have been
indicating
since we went near term neutral on the equity markets in late
November,
the market seemed ahead of itself in terms of earnings fundamentals,
but
was being carried forward on revived investor expectations and
Fed-driven
liquidity. Unfortunately, as we noted in a strategy morning
call note on
February
1, 2001, the liquidity push has slowed down measurably via M2
money
supply
contraction (since mid-December) and the FOMC's decision to stand
pat on
interest
rates in late January. In
addition, the near term earnings picture
remains
mixed. Herein lies the
market's susceptibility to the
accounting/disclosure
assaults, be they real or imagined.
As
is normally the case, GDP recovery does not mean simultaneous
earnings
rebounds. As a reminder, the U.S. economy came out of
recession in 1991, but
the
S&P 500 still managed a 15% drop in EPS that year. And, as we have tried
to
explain, 2002 has similar issues to work through. Typically, GDP turns lead
earnings
by about two quarters; hence, our expectations for 2H02 EPS gains
in
the
15%-20% range seem quite reasonable as does our belief that 1Q02
EPS will
be
down year over year. While
this may not be what investors want to hear,
historical
relationships are very much on our side.
Thus, as the liquidity
push
wanes and earnings are not yet ready to do the heavy lifting,
we have a
gap
in fundamental market drivers that causes a less than seamless
transition.
In
this "gappy" period, accounting "poison" darts
can do damage with emotional
selling
overwhelming a rational review of the facts.
As one investor described
it
to us, "One can be labeled a criminal by the press and even
if the
individual
is innocent, it will take time to present compelling evidence
to
that
end -- in the meantime, everyone shuns that person because of
the well-
publicized
accusation." Thus,
we would like to present some of that evidence
when
it comes to the broader equity markets, recognizing that it could
take
some
time for investors to get over front page headlines that seemingly
accuse
every
company of shading the truth with accounting gimmickry.
Four
Reasons To Believe In The Market's Earnings
* Earnings Could Have Been Better Manipulated
As
one can see in Figure 1, S&P 500 EPS trends match up quite
well with
industrial
activity trends and the roughly 16-month slide in industrial
production
tracks well with weak EPS direction -- as has been the case for
30
years! Indeed, we have been showing investors this
relationship since July
2001;
thus the news of alleged fraud at one or two companies does not
alter the
broader
implications. In addition,
the drop in 2001 operating EPS for the S&P
500
is likely to be something in the vicinity of 20%-21% when all
the numbers
come
in, the worst annual earnings decline since 1938. One would have thought
that
if companies were manipulating numbers across the board, they
would have
done
a better job, especially given the mildness of 2001's recession.
Figure
1: (figures can be seen
in PDF format)
Source: Salomon Smith Barney and DRI
* Corporate Margins Look Pretty Recession-Like
When
we look at the sharp decline in corporate margins (Figure 2),
we see that
this
recession's margin downturn seems quite similar to past periods,
with this
data
being sourced from the national income accounts, not S&P 500
company
filings
with the SEC. Thus, once
again, we can witness fairly similar
historical
experiences from a different set of inputs showing pretty consistent
patterns. Thus, once again, the accounting concerns seem
to be more a series
of
insinuations without broad data backup.
Figure
2. (figures can be seen
in PDF format)
Source: Salomon Smith Barney, DRI and BEA
* One-Time Write-offs
As
can be seen in Figure 3, the concept of one-time charges, discontinued
operations
and special items seems to be one of the repercussions of recessions
as
such items accounted for 75% of S&P 500 net income after the
1990-91
recession
and just above 85% this time around.
The goodwill write-offs being
caused
by accounting treatment changes is somewhat similar to new requirements
in
1992 for companies to address retiree heath care and pension liabilities.
At
the time, many companies were compelled to take large charges
as well, with
one
well-known consumer durable goods manufacturer experiencing a
book value
correction
from $25 to $5 overnight, without impairing the company's ability
to
run
its business or generate margin recovery.
Indeed, we recall many companies
that
made aerospace industry-related acquisitions taking goodwill write-offs
in
1991
and 1992 due to the military spending cutbacks and the realization
that
they
had overpaid for assets in retrospect.
Thus, the tech bubble write-offs
concept
are far from unprecedented. As
such, we think using the asset charge-
offs
as proof of accounting manipulation seems to be less than valid.
Figure
3: Write-offs as &
of Net Income
Source: Salomon Smith Barney and FactSet
* The PNC Experience
The
equity market was rocked not only by the Enron bankruptcy, but
also by Tyco
fears
and the PNC Financial need to restate numbers.
But, PNC was forced to
adjust
their numbers within a week of reporting them.
Thus, if anything, one
would
argue that the scrutiny in the U.S. is much more effective than
anyone
might
imagine. While Japanese
banks have been able to go on for years without
recognizing
their issues, the Fed challenge has enhanced the concept of U.S.
transparency,
not diminished it. Unfortunately,
many people forget that there
have
been past experiences of fraud or alleged fraud (Lernout &
Hauspie, for
instance, happened only about a year ago) and that one
should not extrapolate
the
outliers into a trendline for the majority of companies. It is unfortunate
that
the bankruptcies of Enron, Global Crossing, Kmart and others occurred
in a
very
short time frame, alongside the restatements by PNC and Anadarko
Petroleum,
but we would be careful in attempting to indict all of corporate
America
for practicing accounting irregularities.
The
Gap Between Liquidity and Earnings Should Close In Time
In
our view, if major companies were to tell us that orders were
picking up and
money
managers got a hint of earnings visibility, the accounting issues
would
fade
from the limelight. It
is this gap condition between liquidity and
earnings
being the market driver that has allowed the markets to slip and
we
think
that should change over the next month or two as orders trends
begin to
demonstrate
the impending turn in industrial production tied to inventory
rebuilding. In fact, simply raising production to meet
final demand (which has
stayed
resilient based on recent same store sales data and auto sales)
should
drive
earnings higher. Note
that this does not affect all sectors similarly.
Industrial
activity drives manufacturing more than imports and, in this
context,
tech should lag. As a
reminder, GDP trends generally lead earnings by
a
quarter or two and profits lead capital spending by another quarter
or two as
well. Thus, while IT should improve with the economy
(as many have argued), it
does
so with a meaningful lag. Moreover,
overall IT margins could stay under
pressure
due to extremely low capacity utilization (roughly 60%) even as
demand
picks
up. Hence, we remain underweight
the IT sector.
To
be fair, though, IT stocks have taken a beating in the last few
weeks
(through
February 7th), with the S&P Information Technology off 15.6%
from
recent
highs vs. the S&P 500 being down only 7.8%. Indeed, the Dow Jones has
slipped
only 6.2% vs. the 13.3% decline in the Nasdaq
Composite. When
looking
at
specific tech industry leaders, Sun Microsystems has fallen 33.8%
from its
January
highs, JDSU has plunged 37.1% only to be outpaced by Corning's
39.8%
collapse
and Juniper Networks' 38.0% fall.
EMC has dropped 20.8% and Cisco is
down
18.8% while IBM has skidded 16.8% and eBay has fallen 18.5% and
Yahoo has
backed
off 23.3%. All in all,
a very sorry performance.
The
End of Rate Cuts Is a Positive Based on History
One
piece of good news is that if we can look out past the near term
lack of
drivers,
the likely cessation of Fed rate cuts is actually a good sign
for
equities
based on historical performance.
As can be seen in Figure 4, when
looking
at the discount rate data since 1930 (fed funds data since the
early
1990's),
we have come up with a list of 17 periods in which the markets
have
experienced
a final rate cut and the market's performance thereafter, on
average,
has been solid. In fact,
the average 12-month S&P 500 gain after a
final
cut has been 19.4% and the index experienced positive returns
in 14 of
the
17 periods analyzed. Moreover,
if we eliminate the two periods in which
there was only one cut (and thus hardly qualifying
as an easing cycle), the
average
performance of the S&P 500 index increases to an even more
respectable
21.7%,
with only two periods of negative performance.
Yet, since the two
largest
outliers in terms of performance occurred during the Great Depression,
we
feel that one should further refine the data and look at the average
excluding
the 5/8/1931 and 6/24/1932 periods.
Therefore, the average
performance
is reduced to 19.8%, which is still a very respectable return,
with
only
one period of negative 12 month performance.
Figure
4 (Figures can be seen
in PDF format)
Feb-11-2002
11:54 GMT
-------------------
AY:
Monday Morning Musings: Why
Have Equities Been So Vulnerable? (Part 2 of 2)
06:53am
EST 11-Feb-02 Salomon Smith Barney Intl
(Tobias M. Levkovich +x-xxx-xx
In
addition to the S&P 500 index, we decided to check the major
sectors'
performance
after a final rate cut to get a better sense of what segments
tend
to
lead the market's strong performance.
Thus, we present the average
performance
after the most recent six final rate cuts in Figure 5. Two of the
sectors
we are currently slightly overweight, Consumer Discretionary and
Financials,
have both outperformed the market in such an environment.
Additionally,
we believe the robust performance of the Information Technology
sector
also may prove deceptive. In
this case, the sector has experienced very
erratic
performance. In fact,
the IT sector was up over 60% and up close to
90%
in the 12 months following both the 1/31/1996 and 11/17/1998 periods,
respectively,
and skews the average, in our opinion.
The other sector we are
slightly
underweight is Healthcare, which generally has underperformed
following
the end of an easing cycle. This
should not be surprising given the
probability
of a lack of relative cyclical earnings power.
Lastly, we would
point
out that the Energy sector's performance was a surprise, but was
largely
due
to the 55.6% the index rose in the 12 months following the 8/21/1986
period.
Figure
5 (Figures can be seen
in PDF format)
Source: Salomon Smith Barney and FactSet
While
we do not yet see a clear positive catalyst to propel the market
higher
right
now, we would emphasize that the end of rate cuts do not imply
the end of
market
upside appreciation potential, but we may need to wait a few more
weeks
for
signs of earnings visibility (most likely from rising order activity).
Thus,
we are still awaiting indications of possible triggers for a more
aggressive
posture relative to the equity markets, but we also believe the
risks
are beginning to diminish as some of the market froth earlier
this year
has
started to dissipate.
Companies
Mentioned
Anadarko
Petroleum Corp (APC-$47.59; 3M)
Cisco
Systems Inc (CSCO-$17.06; 1H)
Corning
Inc.# (GLW-$6.44; 3H)
EMC
Corp. (EMC-$13.76; 1M)
International
Business Machines# (IBM-$103.91; 1M)
JDS
Uniphase (JDSU-$6.30; 3S)
Juniper
Networks# (JNPR-$13.41; 2S)
Kmart
Corp. (KM-$0.95; 3S)
PNC
Bank# (PNC-$53.93; 2L)
Sun
Microsystems, Inc.# (SUNW-$9.22; 3H)
Tyco
International Ltd.# (TYC-$28.05; 1H)
Yahoo!
Inc. (YHOO-$15.35; 1H)
eBay#
(EBAY-$54.96; 2H)
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