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

 

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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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