Investment Strategy Weekly

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1 Research Investment Strategy Weekly August, 2 THE MARKET NEEDS A VACATION Why does the stock market always soar when I go on vacation? I was on vacation at the end of y. Stock prices soared. Before I get flooded with s requesting my vacation schedule, I should admit that there have been a few times when the market plunged while I was away. In any event, my vacations are almost always disturbed by a big move in the market. As an investment strategist, I am expected to have an analysis and opinion about any major swings in stock prices. So I managed to write my commentary just after the fourday, 1317-point, and 17.6% intra-day rally in the Dow Jones Industrials Average (DJIA). This was the biggest four-day gain ever, and the greatest four-day percentage gain since My conclusion is that the intra-day low of 749 on Wednesday, y 24 was probably the long-sought and oft-anticipated low for the year. All disclosures can be found on the back page Dr. Edward (212) ed_yardeni@prusec.com The Dog Days Of Summer. The bad news is that the rally could stall and the market might drift sideways for a while. If it does so only through the end of the summer that would actually be good news for those of us who would like to take just one more (quiet) week off before the kids come back from camp and start school. Of course, we are all focused on August 14 because, on or about that date, the CEOs of America s largest corporations must certify with their signature that the financial statements filed with the Securities and Exchange Commission are accurate, to the best of their knowledge. Needless to say, if any CEO knowingly committed fraud, odds are he will sign the SEC s affidavit rather than disclose the crime and become a member of America s Most Wanted CEOs. Still there could be a few honorable CEOs who might need more time to review their books, and might have to restate earnings. They ll Be Back! Last week, my case for a y 24 major bottom was based on the simple notion that investors were relieved that Congress passed legislation to address the corporate accounting and governance crisis. Investors were also probably just as relieved that Congress will be in recess for the rest of the summer. But our lawmakers will be back, and they could agitate investors again. Incumbent Democrats, in particular, might have a better chance of winning more seats in Congress in the coming November elections if the voters remain upset about the stock market and the economy. Of course, I m not suggesting that any of our well-intentioned politicians might take advantage of a bad financial and economic situation for their own political gain, though the thought has crossed my mind over the past few months as I watched the Congressional hearings and the Sunday morning TV talk shows for political junkies. August, 2

2 R E S E A R C H Investment Strategy Weekly If our Congressional legislators want to do something very constructive this fall, I suggest they vote to exclude dividends from personal income taxation. In my opinion, this could be an important step in promoting the interests of the Investor Class. Our capitalist system works, but it does on occasions need to be repaired and reformed. Fed Chairman Alan Greenspan seems to agree that the double taxation of dividends may be partly to blame for the corporate accounting and governance crisis. On y 16, 2, he testified before Congress on the state of the economy and provided the Fed s semiannual Monetary Policy Report. In a subsequent discussion about earnings and dividends with Senator Bob Bennett (R-Utah), Mr. Greenspan said: This goes back years, grant you. But people bought stocks for dividends; they did not buy them for earnings. And one of the problems that we did not have back then is earnings manipulations [, which] were not very important because nobody cared. Earnings are very difficult to estimate. In fact, there is no such thing as an objective earning level.at root, this question the most fundamental aspect of this question really gets down to the double taxation of dividends I ll have more to say on this subject in coming weeks. The Market Is Cheap Relative To Bonds The rally at the end of y was overdue as most technical indicators showed that stocks were oversold and undervalued starting in late June. At the y 24 low of 749, the DJIA had retraced roughly one-third of the long-term bull run from 777 in 1982 to 11,722 in (Figure 1). Earlier this year, the bears said that the market s forward P/E was too high at. They observed that historically is the average. Well, at the end of y, they got their wish; the P/E fell to 14.9, the lowest reading since September 1996 (Figures 2 and 3). Back then the 1-year bond yield was 6.9%, well above today s 4.3%. In other words, a P/E around made more sense back then than it does today based on the bond yield. But Investors See Less Earnings Growth And May Be Willing To Pay Less For It. However, the recent sharp drop in the P/E might be attributable to a major downward revision in investors expectations for long-term earnings growth. Analysts raised their three-to-five year earnings growth projections dramatically during the 199s, from 11.4% at the start of the decade to an all-time peak of 18.7% during August. In y, their consensus forecast for long-term earnings growth was back down to 13.3%, the lowest reading since June 1997 (Figure 3). 1 The ratio of the forward P/E to the consensus long-term expected growth in earnings the PEG ratio plunged from 1. at the beginning of this year to y s 1.2, which happens to be the average for this ratio since 198 (Figure 4). Staying In The Playing Field, But Close To The Sideline. I remain basically optimistic about the outlook for the economy, profits, and the stock market. I also expect that once the CEOs sign on the dotted line, on or about August 14, the corporate accounting and governance crisis should be a greatly diminished concern among stock investors. My valuation model based 1 These expectations of industry analysts are compiled monthly by Thomson Financial. 2 August, 2

3 R E S E A R C H Investment Strategy Weekly on the relationship between the bond yield and the current earnings yield for the S&P shows that stocks remain undervalued even after the dramatic late y rally. Nevertheless, I am staying with the relatively defensive bonds/stocks mix for a Moderately Aggressive investor of 3/6 and a cash/bonds/stocks mix for a Moderate investor of 1//4, which I ve recommended since WorldCom s shocker on June 26. While the corporate accounting and governance crisis may become less of a concern, a new issue is the Double-Dip scenario for the economy. Double Dipping Indicators. It started to trouble the market on y 12, when the University of Michigan s Survey Research Center announced that their Consumer Sentiment Index dropped sharply at the beginning of the month. The final numbers for y, released y 26, showed a drop to 88.1 from 92.4 in June. June s 3.8% drop in durable goods orders, released on y, was the second major downbeat indicator to unsettle investors confidence in a sustainable economic recovery. On y 31, we learned that real GDP rose only 1.1% during the second quarter, and the first quarter s results were revised from an increase of 6.1% to.%. Nominal GDP, which is a measure of business sales is up only 3.2% over the past four quarters (Figure ). On August 1, stock prices fell sharply again because of a weaker-than-expected survey of national purchasing managers conducted by the Institute for Supply Management (ISM). The CRB raw industrials spot price index, one of my favorite daily indicators, has been flat since early y, after staging a solid recovery earlier this year. The 1-year Treasury bond yield has declined from.38% during the week of March 28 to 4.3% recently. The stock prices of retailers are down sharply in recent weeks. Looking Up. The good news is that despite the disappointing real GDP and ISM numbers, industrial production is recovering (Figure 6). Even with the downward revisions for last year s real GDP, the recession of 1 was among the mildest. Therefore, we shouldn t be surprised if this year s recovery is unimpressive. Think of this year as a typical expansion year with real GDP rising 3%, rather than a recovery year with a huge rebound in economic growth. Here s some more good news: 1) y s car sales were very strong. 2) June s new home sales were at a record. 3) Mortgage applications to buy a home are soaring. 4) Mortgage refinancing activity is up sharply again. I am not ready to give up on the consumer. I continue to favor consumer stocks, especially of companies in housing-related and mortgage financing businesses. Despite press reports suggesting that the home real estate market may be weakening, I remain positive on the industry. While money is coming out of equity mutual funds, it is pouring into savings deposits, which means there is plenty of cheap money available to boost housing (Figure 7). In June, the average existing home price was up 1.4% from a year ago, the first double-digit appreciation rate since the early 199s (Figure 8). My favorite industry for the longer-term is the health care sector, including services, equipment, pharmaceuticals, and biotech. 3 August, 2

4 R E S E A R C H Investment Strategy Weekly Tech Remains Very Earnings & Valuation Challenged. While there are undoubtedly some great investment opportunities among the survivors of the Tech Wreck, I remain cautious on the sector on a fundamental basis. Too many of the great technological innovations of the 199s have been commoditized. Prices are falling and unit sales are simply not as great as they were in the late 199s. Telecom and Banking, two of the biggest customers for technology, are depressed. My latest poll of Chief Information Officers (CIO) confirms that the outlook for tech spending remains subdued. 2 In y, the CIOs projected that their information technology (IT) budgets would increase only.% over the next 12 months. They said that there has been virtually no growth over the past 12 months since February of this year (Figure 9 and Figure A, row 2). The percent of respondents planning to increase spending over the next 12 months on eight unique categories of IT hardware, software, and services fell to 41.% in y from 43.2% in June (Figure 1 and Figure A, row 11). The CIO Magazine Tech Future Growth Index fell to 2.2 in y, the lowest reading since February (Figure A, row 1). 3 Of the eight budget categories, Computer Hardware has the best prospects with.% of the panelists saying they plan to increase future spending (Figures 11 and 12). Most disturbing is that 41.% of the CIO panelists confirmed that they do not expect a pickup in their IT spending until after 2. This is up from 26.% who held this view in May. The number one negative for IT spending is weak profits according to 34.% of the voters, while another 34.% said tight financial conditions are the main obstacle. The poll suggests that IT vendors are likely to remain earnings challenged through the end of the year. In y, Tech industry analysts estimated that 2 earnings will be down 4% from last year. However, they expect 3 results to be up 6%, but only back to 1998 levels. But even this may be too optimistic since analysts continue to slash their 2 and 3 estimates (Figure 13). 4 Valuation is another challenge facing Tech stocks. In y, the forward P/E was That is down from 47.8 at the end of last year. But it is still at a significant premium to the market multiple. Prior to 1998, Tech traded at the same P/E as the overall S&P (Figure 14). I still expect that Tech will be trading at the market s multiple when the Tech Wreck is finally over. * * * 4 2 I conduct the poll in partnership with CIO Magazine. 3 The projected growth rate of IT budgets over the next 12 months multiplied by the average percentage of respondents saying they plan to increase their spending on eight unique categories. 4 For a similar earnings analysis of the major Tech industry groups, as well as all the other sectors and key industries in the S&P, see Earnings Month at August, 2

5 R E S E A R C H Investment Strategy Weekly Figure A. CIO Magazine Tech Poll - Summary Results Summary Results 2 1 Jun May Apr Mar Feb Jan Dec Nov Oct Sep Aug 1. CIO Magazine Technology Growth Indicators Tech Future Growth Index* IT budget (% increase)** Past 12 months Next 12 months IT future spending on Computer Hardware Increase Decrease Unchanged IT future spending on Data Networking Equipment Increase Decrease Unchanged IT future spending on Telecom Equipment Increase Decrease Unchanged IT future spending on Storage Systems Increase Decrease Unchanged IT future spending on Outsourced IT Services Increase Decrease Unchanged IT future spending on Infrastructure Software Increase Decrease Unchanged IT future spending on ebusiness Applications Software Increase Decrease Unchanged IT future spending on Security Software Increase Decrease Unchanged IT future spending on 3-1 (average) Increase Decrease Unchanged B2B2C % of IT budget Past 12 months Next 12 months B2B2C % of revenues Past 12 months Next 12 months Purchases over the Internet (% of total) Past 12 months Next 12 months Compensation (% increase) Past 12 months IT labor supply Plentiful Available Hard to find Number of Voters * Projected growth rates of IT budgets over the next 12 months multiplied by average percentage of respondents saying they plan to increase their spending on eight unique categories. ** Excludes all responses greater than 1%. Source: CIO Magazine Tech Poll August, 2

6 1 11 Figure 1. DOW JONES INDUSTRIAL AVERAGE 1 11 Dow s -day moving average falls below 1, in / day moving average Source: Dow Jones Inc Figure 2. S&P VS CONSTANT P/E SERIES S&P should find a bottom at current multiple. A 1 multiple is possible if mutual fund redemptions continue at rapid pace S&P Index (as of 7/26) Forward Earnings * P/E * 2-week forward consensus expected S&P operating earnings per share. Monthly through April 1994, weekly thereafter. Source: Thomson Financial and Standard & Poor s Corporation. Page 6 / August 2, 2 / Prudential Securities Investment Strategy Weekly

7 Bond yield suggests that fair-value P/E is Actual P/E plunged from.7 in March to 14.9 at the end of y. Could it be that investors are lowering their forecasts of long-term earnings growth as analysts have been doing? PEG ratio is now back to historical average Figure 3. P/E RATIO FOR S&P & EARNINGS GROWTH Ratio of S&P Price to Expected Earnings* Long-Term Earnings Growth** * 2-week forward earnings consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. ** -year forward consensus expected earnings growth. Source: Thomson Financial and Standard & Poor s Corporation Figure 4. S&P PEG RATIO P/E ratio for S&P divided by -year consensus expected earnings growth* 7/ Average = * P/E using 12-month forward consensus S&P expected earnings and prices at mid-month. Source: Thomson Financial. Page 7 / August 2, 2 / Prudential Securities Investment Strategy Weekly

8 At 3.2%, year-over-year percent change in nominal GDP remains very low. Revenue growth for S&P 4 is likely to rebound this year, but outlook is subdued given weak growth in nominal GDP. 3 1 Figure. S&P SALES VS NOMINAL GDP (yearly percent change) Nominal GDP S&P 4 Sales Per Share Q Q Source: U.S. Department of Commerce, Bureau of Economic Analysis and Standard & Poor s Corporation No sign of Double Dip yet in the production indicators, which appear to be recovering from last year s recession Figure 6. INDUSTRIAL PRODUCTION INDEXES (1992=1) Business Week s Production Index* Fed s Industrial Production Index: All Industries * Four-week average. Includes auto, truck, coal, lumber, electric power, rail-freight traffic, crude oil refining and steel production. Source: Board of Governors of the Federal Reserve System and "Business Week," McGraw-Hill, Inc. 7/ Jun Page 8 / August 2, 2 / Prudential Securities Investment Strategy Weekly

9 6 Figure 7. SAVINGS DEPOSITS & EQUITY MUTUAL FUNDS 6 Savings deposits yielding 1% or less have become a much more popular asset than equity mutual funds. Plenty of cheap money should be available for mortgages Saving Deposits (2-week change, billion dollars) Net Inflows Into Equity Mutual Funds (12-month sum, billion dollars) 7/22 Jun Source: Board of Governors of the Federal Reserve System and Investment Company Institute. - Figure 8. EXISTING HOME PRICE (yearly percent change) Average Price Let the bubble begin! Average existing home price up 1.4% from a year ago. First double-digit appreciation rate since early 199s. 1 Median Price Jun Source: National Association of Realtors. - Page 9 / August 2, 2 / Prudential Securities Investment Strategy Weekly

10 24 Figure 9. CIO TECH POLL: FUTURE & CURRENT GROWTH RATES 24 CIOs continue to project very modest increases in IT budgets. Most cite weak profits and tight financial conditions as major restraints IT Budget Growth Rates Current (last 12 months) Future (next 12 months) Aug Sep Oct Nov Dec Jan FebMar Apr May Jun Aug Sep Oct Nov Dec Jan FebMar Apr May Jun 1 2 Source: CIO Magazine Tech Poll Figure 1. CIO TECH POLL 7 6 CIO poll suggests that outlook for Tech industry remains challenging CIO Magazine Tech Future Growth Index* CIO TECH POLL: FUTURE IT SPENDING PLANS ON EIGHT UNIQUE CATEGORIES** (% of respondents planning to increase spending over the next 12 months) Feb Mar Apr May Jun Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun 1 2 * Projected growth rate of IT budgets over the next 12 months multiplied by average percentage of respondents saying they plan to increase their spending in eight unique categories. ** The "plan to increase" responses are averaged together for the following categories: computer hardware, data networking equipment, telecom equipment, storage systems, outsourced IT services, infrastructure software, e-business software, and security software. Source: CIO Magazine Tech Poll. Page 1 / August 2, 2 / Prudential Securities Investment Strategy Weekly

11 7 Figure 11. CIO TECH POLL: FUTURE IT SPENDING PLANS (percent of respondents planning to increase spending) 7 6 Storage Systems Computer Hardware Data Networking Equipment Telecom Equipment Percent of CIOs planning to increase spending looks better for Computer Hardware, Storage Systems, and E-Business Software; and worse for the other categories. 7 Source: CIO Magazine Tech Poll. Figure CIO TECH POLL: FUTURE IT SPENDING PLANS (percent of respondents planning to increase spending) 7 6 E-Business Software Infrastructure Software Outsourced IT Services Security Software Source: CIO Magazine Tech Poll. Page 11 / August 2, 2 / Prudential Securities Investment Strategy Weekly

12 Tech forward earnings flattening this year after briefly rebounding earlier this year. 2 earnings expected to be down 4% from 1. 3 expected to be up 6%, but only back to 1998 level. Analysts still slashing 2 and 3 estimate. 1 Figure 13. S&P INFORMATION TECHNOLOGY OPERATING EARNINGS PER SHARE (analysts average forecasts, ratio scale) Consensus Forecasts 12-month forward Annual estimates Source: Thomson Financial. Long-term expected growth down from record 29% in late to 18% now. Still selling at high premium to market multiple. Prior to 1998, Tech traded at same multiple as market s Figure 14. S&P INFORMATION TECHNOLOGY VALUATION & GROWTH P/E* Earnings Growth** P/E Relative to S&P * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. ** -year forward consensus expected earnings growth. Percent annual rate. Source: Thomson Financial.. Page 12 / August 2, 2 / Prudential Securities Investment Strategy Weekly

13 R E S E A R C H Investment Strategy Weekly The research analyst(s) or a member of the research analyst s household does not have a financial interest in any of the tickers mentioned in this report. The research analyst or a member of the team does not have a material conflict of interest relative to any stock mentioned in this report The research analyst has not received compensation that is based upon (among other factors) the firm s investment banking revenues as it related to any stock mentioned in this report The research analyst, a member of the team, or a member of the household do not serve as an officer, director, or advisory board member of any stock mentioned in this report Prudential Securities has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of % or more over the next 12 to 18 months. For higher risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline % or more over the next 12 to 18 months. For lower risk stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell. Rating distribution 8/1/2 Firm IBG Clients Buy 41.% 3.% Hold 7.%.% Sell 2.%.% Excludes Closed End Funds Any OTC-traded securities or non-u.s. companies mentioned in this report may not be cleared for sale in all states. 2-XXXX Securities products and services are offered through Prudential Securities Incorporated, a Prudential company. Prudential Securities Incorporated, 2, all rights reserved. One Seaport Plaza, New York, NY 1292 Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such information has not been verified by us, and we do not make any representations as to its accuracy or completeness. Any statements nonfactual in nature constitute only current opinions, which are subject to change. Prudential Securities Incorporated (or one of its affiliates or subsidiaries) or their officers, directors, analysts, employees, agents, independent contractors, or consultants may have positions in securities or commodities referred to herein and may, as principal or agent, buy and sell such securities or commodities. An employee, analyst, officer, agent, independent contractor, a director, or a consultant of Prudential Securities Incorporated, its affiliates, or its subsidiaries may serve as a director for companies mentioned in this report. Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation of an offer to buy any securities or commodities mentioned herein. There may be instances when fundamental, technical, and quantitative opinions may not be in concert. This firm (or one of its affiliates or subsidiaries) may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange rate fluctuations, and limited availability of information on international securities. Prudential Securities Incorporated, its affiliates, and its subsidiaries make no representation that the companies which issue securities which are the subject of their research reports are in compliance with certain informational reporting requirements imposed by the Securities Exchange Act of Sales of securities covered by this report may be made only in those jurisdictions where the security is qualified for sale. The contents of this publication have been approved for distribution by Prudential-Bache International Limited, which is regulated by The Securities and Futures Authority Limited. We recommend that you obtain the advice of your Financial Advisor regarding this or other investments. Additional information on the securities discussed herein is available upon request. August, 2