Table Of Contents. Table Of Contents. OAK ASSOCIATES, ltd.

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1 Table Of Contents Table Of Contents Tables A: Scenarios 1 B & C: S&P Earnings Forecasts 2 D & E: Top 12 & Bottom 12 3 F: S&P Industry Overweights 4 G: S&P Industry Underweights H: S&P Industry Performance 6 I: O-M-U Recommendations 7 Figures US Stock Price Trends 8-9 Profits Profit Margin 11 Cash Flow 12 Profits & Sales 13 S&P Write-Offs 14 S&P Dividends S&P Dividend Yield 16 S&P Quarterly Earnings 17 S&P Earnings Squiggles: Monthly 18 S&P Forward Earnings Forward Earnings: Industrial Orders Forward Earnings: IT & Semis 2 Forward Earnings: Semi Equipment 26 Forward Earnings: Materials & Energy 27 Forward Earnings: Energy 28 Forward Earnings: Diversified Banks 29 Valuation: P/E Ratios 3 Valuation: P/E & q 31 Valuation: SVM-1 32 Valuation: SVM-2 33 Valuation: Equity Risk Premium 34 Valuation: Bond Yield 3 Valuation: Market Cap 36 Market Cap 37 S&P Sector Shares S&P /4/6 YTD 4 Russell Indexes: vs 41 Russell Index: Four Styles 42 Relative Earnings & P/E: S&P Sectors Relative Earnings & P/E: Consumer 47-2 Relative Earnings & P/E: Energy 3-4 Relative Earnings & P/E: Financials -6 Relative Earnings & P/E: Health Care 7-8 Relative Earnings & P/E: Industrials 9-6 Relative Earnings & P/E: IT Relative Earnings & P/E: Materials 63-6 Relative Earnings & P/E: Telecom Services 66 Relative Earnings & P/E: Utilities 67 S&P Sectors STEG 68 S&P Sectors STEG vs LTEG 69 S&P Sectors LTEG 7 Real Pay 71 Consumer Optimism Index 72 US Consumers: Retail Sales 73 US Consumers: Assets 74 US Consumer: Mutual Funds 7 US Consumers: Real Estate 76 US Consumers: Debt 77 US Capital Spending 78 Inflation Pricing 82 US Monetary Policy 83 Global Money Supply 84 Trade Deficit 8 Foreign Purchases of US Treasuries 86 US Capital Inflows 87 FRODOR 88 US Dollar & Gold 89 Global Earnings 9 Global P/Es 91 G7 Industrial Production 92 China: Exports & Imports 93 July 2, 6 / Strategist s Handbook

2 - A: Scenarios - Page 1 / July 2, 6 / Strategist s Handbook

3 - B & C: S&P Earnings Forecasts - Page 2 / July 2, 6 / Strategist s Handbook

4 - D & E: Top 12 & Bottom 12 - Page 3 / July 2, 6 / Strategist s Handbook

5 - F: S&P Industry Overweights - Page 4 / July 2, 6 / Strategist s Handbook

6 - G: S&P Industry Underweights - Page / July 2, 6 / Strategist s Handbook

7 - H: S&P Industry Performance - Page 6 / July 2, 6 / Strategist s Handbook

8 - I: O-M-U Recommendations - Page 7 / July 2, 6 / Strategist s Handbook

9 The S&P has increased at a compounded rate of 7% per year on average since Figure 1. - US Stock Price Trends - S&P INDEX* (ratio scale) 7% % * Growth paths are compounded monthly to yield % and 7% annually. Note: Shaded areas are recessions according to the National Bureau of Economic Research. Source: Standard & Poor s Corporation. DJIA has been consolidating around, following the great bull market of the 198s and 199s Figure 2. DOW JONES INDUSTRIALS (ratio scale), Note: Shaded areas are recessions according to the National Bureau of Economic Research. Source: Dow Jones Inc. Page 8 / July 2, 6 / Strategist s Handbook

10 From 196 to 1982, the DJIA fluctuated in a volatile range between and with several bull and bear markets Figure 3. - US Stock Price Trends - DOW JONES INDUSTRIALS: (Monthly) % +48.4% +66.7% +32.9% % -21.1% -24.% -.% % % -41.9% Note: Shaded areas are recessions according to the National Bureau of Economic Research. Source: Dow Jones Inc Figure 4. DOW JONES INDUSTRIALS: (daily closing price) Peak = 11,723 1 The DJIA traded in a volatile, flat range north of, from 1999 through early 2. It traded south of, from mid-2 to the end of 3. Now it is once again over, / Trough = Source: Dow Jones Inc. 7 7 Page 9 / July 2, 6 / Strategist s Handbook

11 13 1 Figure. - Profits - S&P & NIPA CORPORATE PROFITS BASED ON TAX RETURNS* (billion dollars) Q NIPA after-tax profits based on tax returns at record high during Q1 6. This measure of profits excludes write-offs, so it is similar to S&P operating net income rather than to S&P reported net income. Cash flow profits (from current production) at record high in Q1 6 also NIPA After-Tax Profits Based on Tax Returns* (saar) NIPA After-Tax Profits From Current Production** (saar) S&P Net Income (4-quarter sum) Operating Reported Q * Excluding IVA & CCadj. ** Including IVA & CCadj. These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. Source: US Department of Commerce, Bureau of Economic Analysis, and Standard & Poor s Corporation Figure 6. S&P OPERATING NET INCOME (total, 4-quarter sum) (as a ratio of NIPA after-tax corporate profits based on tax returns, saar)* When this ratio is above (below) average, S&P earnings may overstate (understate) actual profits Average = Q * Excluding IVA & CCadj. These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. Source: US Department of Commerce, Bureau of Economic Analysis, and Standard & Poor s Corporation. Page / July 2, 6 / Strategist s Handbook

12 - Profit Margin - 12 Figure AFTER-TAX CORPORATE PROFITS FROM CURRENT PRODUCTION* As a percent of National Income As a percent of Nominal GDP Q PROFIT MARGIN* FROM CURRENT PRODUCTION (percent) Q All Corporations Average =.2% PROFIT MARGIN & CAPACITY UTILIZATION Nonfinancial Corporate Profit Margin* Capacity Utilization: All Industries Q1 May * After-tax. Includes Inventory Valuation Adjustment and Capital Consumption Adjustment. These two adjustments restate the historical-cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current-cost measures used in GDP. Note: Shaded areas are recessions according to the National Bureau of Economic Research. Source: Board of Governors of the Federal Reserve System and US Department of Commerce, Bureau of Economic Analysis. Page 11 / July 2, 6 / Strategist s Handbook

13 Corporate cash flow continued to set new highs during Q1 6, despite reduced depreciation allowances following the expiration of 2/3 tax law incentives at the end of Figure 8. CORPORATE CASH FLOW (ratio scale, billion dollars, saar) - Cash Flow - Corporate Cash Flow* Economic Depreciation** Tax-Reported Depreciation*** Q1 Q * After-tax retained earnings plus tax-reported depreciation. ** Corporate capital consumption allowances. *** Corporate capital consumption allowances with capital consumption adjustment. Source: US Department of Commerce, Bureau of Economic Analysis. 2 Figure 9. INVENTORY VALUATION ADJUSTMENT* (billion dollars, saar) 2 The Capital Consumption Adjustment contributed significantly to corporate cash flow from 2-4 by boosting tax-reported depreciation expenses. Profits were strong enough during to boost cash flow even as allowable depreciation expenses plunged CAPITAL CONSUMPTION ADJUSTMENT* (billion dollars, saar) Q Q * These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. Source: US Department of Commerce, Bureau of Economic Analysis. Page 12 / July 2, 6 / Strategist s Handbook

14 Figure. - Profits & Sales - NOMINAL GDP & AFTER-TAX CORPORATE PROFITS (196=, ratio scale) Q % appears to be the Magic Number: This has been the trend growth rate of the economy, sales, and profits since the early 196s % Growth Path* Nominal GDP After-Tax Corporate Profits Reported to IRS From Current Production** * Compounded monthly to yield 7% annually. ** Includes Inventory Valuation Adjustment and Capital Consumption Adjustment. Source: US Department of Commerce, Bureau of Economic Analysis. These three alternative measures of earnings often tell three different stories. The market has tended to discount the most optimistic of the three, i.e., forward earnings. Trend suggests earnings could rise to $1 per share by Figure 11. S&P EARNINGS PER SHARE (ratio scale, dollars) S&P Earnings Per Share* Reported (4-quarter sum) Operating** (4-quarter sum) Forward*** 7% Q1 % * Growth paths are compounded monthly to yield % and 7% annually. ** Excludes write-offs. *** 2-week forward consensus expected S&P operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Monthly through April 1994; weekly thereafter. Source: Standard & Poor s Corporation and Thomson Financial. Page 13 / July 2, 6 / Strategist s Handbook

15 Figure S&P Write-Offs - S&P WRITE-OFFS PER SHARE* (dollars) 4-Quarter Sum Q4 Write-offs rose each quarter of 4, but dropped during each quarter of Actual x * Operating less reported earnings per share. Source: Standard & Poor s Corporation. Figure 13. S&P WRITE-OFFS PER SHARE* (as a percent of operating earnings) Q Quarter Sum Q Actual x Q4 - * Operating less reported earnings per share. Source: Standard & Poor s Corporation. Page 14 / July 2, 6 / Strategist s Handbook

16 Figure S&P Dividends - S&P DIVIDENDS & RETAINED EARNINGS PER SHARE (dollars, trailing 4-quarter sum, ratio scale) Q There was a big rebound in retained earnings during 4 and. After the accounting excesses of the past few years, corporations are increasing dividends to boost investor confidence..3.3 Dividends Retained Earnings* Q * Reported earnings minus dividends per share. Source: Standard & Poor s Corporation. 9 8 Figure. S&P DIVIDEND PAYOUT RATIOS* (percent) 9 8 The average dividend payout ratio (using reported earnings) dropped from % during the 19s and 196s to 44% during the 197s, 43% during the 198s, and 41% during the 199s. The percentage of S&P companies paying dividends increased from 7.2% in 2 to 77.2% in, the highest percentage since S&P S&P Industrials S&P COMPANIES PAYING A DIVIDEND (percent of total) Q * Four-quarter trailing dividends per share divided by four-quarter trailing reported earnings. Source: Standard & Poor s Corporation and FactSet. Page / July 2, 6 / Strategist s Handbook

17 - S&P Dividend Yield - Figure 16. TREASURY BILL YIELD VS S&P DIVIDEND YIELD (percent) At 4.7%, the T-bill rate exceeds the dividend yield of 1.8%. Three-Month Treasury Bill Yield S&P Dividend Yield* Q * S&P four-quarter trailing dividends per share divided by quarterly closing S&P index. Source: Standard & Poor s Corporation and Board of Governors of the Federal Reserve System Figure 17. S&P DIVIDEND YIELD (trailing 4-quarter sum) Q Dividend yields may be low now, but they tend to rise over time relative to the initial sum invested Invested in 197 Invested in 198 Invested in 199 Q Q Source: Standard & Poor s Corporation. 2 Page 16 / July 2, 6 / Strategist s Handbook

18 24 - S&P Quarterly Earnings - Figure 18. S&P EARNINGS PER SHARE: CONSENSUS QUARTERLY FORECASTS* (weekly, analysts average forecasts in dollars) Q4 6 By Quarter (as of 6/23/6) Q3 Q Q1 Analysts quarterly earnings estimates for 6 and 7 have been relatively stable. 19 III IV I II III IV 6 * Consensus expected S&P operating earnings per share for each quarter shown. 27 Figure 19. S&P EARNINGS PER SHARE: CONSENSUS QUARTERLY FORECASTS* (weekly, analysts average forecasts in dollars) Q Q Q Q By Quarter (as of 6/23/6) Jan Feb Mar Apr May Jul Aug Sep Oct Nov Dec 6 * Consensus expected S&P operating earnings per share for each quarter shown. 21 Page 17 / July 2, 6 / Strategist s Handbook

19 - S&P Earnings Squiggles: Monthly Figure. S&P OPERATING EARNINGS PER SHARE (analysts average forecasts, ratio scale) Consensus Forecasts 12-month forward* Annual estimates Actual 4Q sum In the past, earnings Squiggles showed that analysts were usually overly optimistic about the earnings outlook. Consensus annual earnings forecasts rose in 4 (for the first time since 199) and also in. 6 estimates still trending higher. Earnings expected to be 13.3% in 6 and.7% in * Time-weighted average of current and next years consensus earnings estimates. Numbers above time line are annual growth rates. Figure 21. S&P OPERATING EARNINGS PER SHARE (analysts average forecasts, ratio scale) Consensus Forecasts 12-month forward* Annual estimates Actual 4Q sum * Time-weighted average of current and next year s consensus earnings estimates. Numbers above time line are annual growth rates. Page 18 / July 2, 6 / Strategist s Handbook

20 Forward earnings is a good leading indicator of operating earnings. Both should continue to rise into record territory in 6. The market tends to discount forward earnings, which should rise to $93 per share by the end of 6. Actual earnings should be $86 in 6, and $93 in S&P Forward Earnings - Figure 22. S&P EARNINGS PER SHARE: FORWARD & ACTUAL (dollars) S&P Earnings Per Share Forward Earnings* (through 6/23/6) Operating Earnings (4-quarter sum) Yardeni Forecasts * 2-week forward consensus expected S&P operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Monthly through April 1994; weekly thereafter. F = Ed Yardeni s forecasts. Figure 23. S&P EARNINGS PER SHARE: FORWARD & ACTUAL (dollars) S&P Earnings Per Share Forward Earnings* (pushed 2-weeks ahead) Operating Earnings (4-quarter sum) * 2-week forward consensus expected S&P operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Monthly through April 1994; weekly thereafter. Q1 F 6/ Page 19 / July 2, 6 / Strategist s Handbook

21 - S&P Forward Earnings Figure 24. S&P EARNINGS & BUSINESS SALES 6/ S&P Forward Earnings* (weekly, dollars per share) Business Sales** (billion dollars, saar) 4 3 S&P forward earnings is highly correlated with business sales. Notice that earnings tend to grow twice as fast as sales. The growth rates of both have peaked, but remain high * 2-week forward consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. Time-weighted average of current and next year s consensus earnings estimates. ** Manufacturing and trade sales. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. Figure 2. S&P EARNINGS & BUSINESS SALES (yearly percent change) / S&P Forward Earnings* (weekly) Business Sales** * 2-week forward consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. Time-weighted average of current and next year s consensus earnings estimates. ** Manufacturing and trade sales. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. Page / July 2, 6 / Strategist s Handbook

22 Figure S&P Forward Earnings - S&P EARNINGS & MONTHLY INDUSTRIAL PRODUCTION S&P Forward Earnings* (dollars per share) Industrial Production (2=) S&P EARNINGS & WEEKLY INDUSTRIAL PRODUCTION (weekly) S&P Forward Earnings* (dollars per share) BusinessWeek Production Index /23 6/ PROFITS (weekly) S&P Forward Earnings* (dollars per share) Weekly Profits Proxy** * 2-week forward consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. Time-weighted average of current and next year s consensus earnings estimates. ** BusinessWeek s industrial production index multiplied by CRB raw industrials spot price index. Source: BusinessWeek, McGraw-Hill, Inc., Commodity Research Bureau, and Thomson Financial. 6/ Page 21 / July 2, 6 / Strategist s Handbook

23 - S&P Forward Earnings - 48 Figure 27. S&P FORWARD EARNINGS & ORDERS 6/23 Apr S&P forward earnings is highly correlated with new factory orders and shipments. Both are back on long-term uptrends S&P Forward Earnings* (weekly) Total New Factory Orders (billion dollars, saar) * 2-week forward consensus expected S&P operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Monthly through April 1994; weekly thereafter. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. Figure 28. S&P FORWARD EARNINGS & ORDERS S&P Forward Earnings* (weekly) Total New Factory Shipments (billion dollars, saar) * 2-week forward consensus expected S&P operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Monthly through April 1994; weekly thereafter. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. 6/23 Apr Page 22 / July 2, 6 / Strategist s Handbook

24 Aerospace & Defense forward earnings highly correlated with aircraft orders. - Forward Earnings: Industrial Orders Figure 29. S&P FORWARD EARNINGS & ORDERS: AEROSPACE & DEFENSE S&P Forward Earnings: Aerospace & Defense* Total Aircraft Orders (12-month sum, billion dollars, saar) May * Time-weighted average of current and next year s consensus estimates. Source: Census Bureau and Thomson Financial. Construction & Farm Machinery & Heavy Trucks forward earnings highly correlated with total shipments of these three industries Figure 3. S&P FORWARD EARNINGS & SHIPMENTS: CONSTRUCTION & FARM MACHINERY & HEAVY TRUCKS S&P Forward Earnings: Construction & Farm Machinery & Heavy Trucks* Shipments** (billion dollars, saar) Apr * Time-weighted average of current and next year s consensus earnings estimates. ** Shipments include farm machinery, construction machinery and heavy duty trucks. Source: US Department of Commerce, Bureau of the Census and Thomson Financial. Page 23 / July 2, 6 / Strategist s Handbook

25 - Forward Earnings: Industrial Orders - Good correlation between Machinery Orders and Industrial Machinery forward earnings Figure 31. S&P FORWARD EARNINGS & ORDERS: INDUSTRIAL MACHINERY Machinery Orders (3-ma, saar) S&P Forward Earnings: Industrial Machinery* May * 2-week consensus expected S&P operating earnaings per share. Time-weighted average of current and next year s consensus earnings estimates. Source: Thomson Financial and Bureau of the Census Figure 32. S&P FORWARD EARNINGS & ORDERS: ELECTRICAL COMPONENTS & EQUIPMENT 2 Ditto for Electrical Equipment industry Electrical Equipment Orders (3-ma, saar) May S&P Forward Earnings: Electrical Components & Equipment* * 2-week consensus expected S&P operating earnaings per share. Time-weighted average of current and next year s consensus earnings estimates. Source: Thomson Financial and Bureau of the Census. Page 24 / July 2, 6 / Strategist s Handbook

26 - Forward Earnings: IT & Semis - 2 Figure 33. S&P FORWARD EARNINGS & SHIPMENTS: INFORMATION TECHNOLOGY Tech shipments and forward earnings have stalled recently after solid rebounds from May S&P Forward Earnings: Information Technology* Manufacturers Shipments: High Tech** (billion dollars, saar) * 12-month forward consensus expected operating earnings per share for the S&P Information Technology sector. ** Computers and electronic products, which include computers and related products, communications equipment, and semiconductors. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. 3 Figure 34. S&P FORWARD EARNINGS & SHIPMENTS: SEMICONDUCTORS 1 3 Semiconductor shipments and orders are relatively volatile, and have been weak recently. 2 May S&P Forward Earnings: Semiconductors* Shipments: Semiconductors (billion dollars, saar) * 12-month forward consensus expected operating earnings per share for the S&P Semiconductors industry. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. Page 2 / July 2, 6 / Strategist s Handbook

27 - Forward Earnings: Semi Equipment Figure 3. S&P FORWARD EARNINGS & BOOKINGS: SEMICONDUCTOR EQUIPMENT Forward Earnings* Bookings (billion dollars, saar, 3-month average) May Semi equipment orders and forward earnings are highly correlated. Industry s stock price index tends to lead bookings * Dollars per share. Time-weighted average of current and next year s consensus earnings estimates. Source: Semiconductor Equipment and Materials International and Thomson Financial. Figure 36. STOCK PRICES & BOOKINGS: SEMICONDUCTOR EQUIPMENT (yearly percent change) Bookings Stock Price Index May Source: Semiconductor Equipment and Materials International and Standard & Poor s Corporation. - Page 26 / July 2, 6 / Strategist s Handbook

28 Materials forward earnings tends to move with industrial commodity prices. - Forward Earnings: Materials & Energy Figure 37. S&P FORWARD EARNINGS & PRICES: MATERIALS S&P Forward Earnings: Materials* CRB Raw Industrials Spot Price Index (weekly) 6/ * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Source: Thomson Financial and Commodity Research Bureau. 22 Figure 38. S&P FORWARD EARNINGS & WORLD CRUDE OIL OUTLAYS* (REVENUES) 4 4 In April, the world s consumers of oil paid $1,737 billion (at an annual rate), up from $433 billion at the end of 1. Producers are enjoying the windfall Total World (billion dollars) Apr S&P Forward Earnings: Energy** * Total world daily crude oil demand multiplied by 36 days and by the US average import crude oil price. ** 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. Source: Energy Intelligence Group, "Oil Market Intelligence" and Thomson Financial. Page 27 / July 2, 6 / Strategist s Handbook

29 - Forward Earnings: Energy - Soaring rig count suggests this industry s earnings should continue to soar too Figure 39. S&P FORWARD EARNINGS & RIG COUNT: OIL & GAS DRILLING S&P Forward Earnings: Oil & Gas Drilling* US Oil & Gas Rotary Rig Count * Time-weighted average of current and next year s consensus earnings estimates. Source: Thomson Financial and International Association of Drilling Contractors & Hughes Tool Company. 3 Figure 4. S&P FORWARD EARNINGS & ORDERS: OIL & GAS EQUIPMENT SERVICES 3 Uptrend in energy capital goods orders is good for Oil & Gas Equipment earnings. 2 S&P Forward Earnings: Oil & Gas Equipment & Services* Mining, Oil Field & Gas Field Machinery Orders (billion dollars, 3-month moving average, saar) 2 Apr * Time-weighted average of current and next year s consensus earnings estimates. Source: Thomson Financial and US Department of Commerce, Bureau of the Census. Page 28 / July 2, 6 / Strategist s Handbook

30 Yield curve and credit-quality spread are key drivers of Diversified Banks earnings growth. Over the past year and a half, the yield curve has been more of a negative than the credit spread has been a positive. - Forward Earnings: Diversified Banks Figure 41. S&P BANKS EARNINGS & YIELD CURVE S&P Diversified Banks Forward Earnings* (yearly percent change) Yield Curve** * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. ** -year Treasury yield less the Fed funds rate. Source: Thomson Financial and the Board of Governors of the Federal Reserve System Figure 42. S&P FORWARD EARNINGS & CORPORATE BOND SPREAD: FINANCIALS S&P Forward Earnings: Diversified Banks* (yearly percent change) 6/ A-Rated Corporate Bond Yield** Less -Year Government Bond Yield (inverted scale, basis points) * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus earnings estimates. ** Moody s Corporate A monthly through 1987, then weekly through. Beginning in 6 S&P Corporate A. Source: Moody s Investors Service, Thomson Financial, and the Board of Governors of the Federal Reserve System. Page 29 / July 2, 6 / Strategist s Handbook

31 Figure 43. P/E RATIOS FOR S&P - Valuation: P/E Ratios - Using 4-quarter trailing reported earnings Using S&P forward earnings* * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Monthly data through April 1994, weekly thereafter. Q1 6/ US EQUITY MARKET CAPITALIZATION: NONFINANCIAL CORPORATIONS (as a ratio of NFC after-tax profits from current production*) NFC P/E S&P Trailing P/E** S&P Average P/E = Q * Including IVA and CCadj. These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. ** Using four-quarter trailing reported earnings. US EQUITY MARKET CAPITALIZATION EXCLUDING FOREIGN ISSUES As a ratio of: After-tax profits from current production* (Avg = 13.8) Corporate Cash Flow** (Avg = 9.1) * Including IVA and CCadj. These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. ** After-tax operating retained earnings plus tax-return-based depreciation. Source: Thomson Financial, U.S. Department of Commerce, Bureau of Economic Analysis, Federal Reserve Board Flow of Funds Accounts, and Standard & Poor s Corporation. Q Page 3 / July 2, 6 / Strategist s Handbook

32 4 Figure Valuation: P/E & q - P/E RATIOS FOR S&P (using 12-month forward earnings*) 4 P/E measures are down sharply from 1999/ peaks. Tech forward P/E remains high, especially relative to S&P P/E. Prior to 1998, Tech usually traded with roughly the same P/E as the overall market S&P Technology Ex Technology * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Data from 199 based on Global Industry Classification Standard. 3. Figure 4. TOBIN S q FOR NONFINANCIAL CORPORATIONS* (ratio) 3. Tobin s q has limited value as a stock valuation model, although it did indicate significant overvaluation during the late 199s Actual q Adjusted q** Q1 Q * Ratio of market value of equities to net worth at market value, which includes real estate at market value and equipment, software, and inventories at replacement cost. ** Actual divided by average since 192. Source: Federal Reserve Board Flow of Funds Accounts. Page 31 / July 2, 6 / Strategist s Handbook

33 Figure 46. STOCK VALUATION MODEL #1 (SVM-1)* (weekly, percent) - Valuation: SVM-1 - Overvalued Undervalued * Ratio of S&P Index to its fair value (2-week forward consensus expected S&P operating earnings per share divided by the -year US Treasury bond yield minus ). Monthly through April 1994, weekly thereafter. 6/ FORWARD P/E & BOND YIELD (SVM-1) (weekly) Ratio Of S&P Price To Expected Earnings* Bond s P/E=Reciprocal Of -Year US Treasury Bond Yield * 2-week forward consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. 6/23 6/ MARKET S ESTIMATE OF EARNINGS (SVM-1) (weekly, dollars per share) S&P Forward Earnings Market s Estimate* Analysts Estimate** * S&P index multiplied by -year government bond yield. Monthly through March 1994, weekly thereafter. ** 12-month forward consensus expected S&P operating earnings per share. Monthly through March 1994, weekly thereafter. Source: Standard & Poor s Corporation and Thomson Financial. 6/23 6/ Page 32 / July 2, 6 / Strategist s Handbook

34 - Valuation: SVM-2-6 Figure 47. STOCK VALUATION MODEL #2 (SVM-2)* (percent) 6 4 Overvalued 4 - Undervalued * Ratio of S&P index to its fair value (12-month forward consensus expected S&P operating earnings per share divided by the difference between Moody s A-rated corporate bond yield less fraction [.] of -year consensus expected earnings growth) STOCK VALUATION MODEL (SVM-2) (ratio scale) Actual S&P 13 7 Fair Value S&P * -year earnings growth weight * Fair value is 12-month forward consensus expected S&P operating earnings per share divided by the difference between Moody s A-rated corporate bond yield less fraction (as shown above) of -year consensus expected earnings growth ADDITIONAL VARIABLES IN SVM-2 Corporate A-rated yield* less -year Treasury yield.1 times Long-term consensus expected earnings growth *Moody s Corporate A monthly through 1987, then weekly through. Beginning in 6 S&P Corporate A. Source: Moody s Investors Service and Thomson Financial. 6/ Page 33 / July 2, 6 / Strategist s Handbook

35 This is another valuation model followed at the Fed. The earnings yield is compared to the real, rather than nominal, bond yield. Spread is Earnings Risk Premium. - Valuation: Equity Risk Premium Figure 48. FED S "EQUITY RISK PREMIUM" MODEL (MONTHLY) -year US Treasury Bond Yield Minus Average Expected CPI Inflation Rate For Next Years (Phili Fed Survey) S&P Expected Earnings To Price Ratio* -Year TIPS Yield** (weekly) * Earnings-price ratio is based on the Thomson Financial consensus estimates of earnings over the coming 12 months. ** Yields on Treasury inflation protected securities (TIPS) adjused to constant maturities. Source: Board of Governors of the Federal Reserve System, US Treasury, Thomson Financial, and Federal Reserve Bank of Philadelphia. 28 Figure 49. ERP 6/ RULE OF : P/E VS BOND YIELD 26 The "Rule of ": The market s forward P/E has often traded around minus the -year Treasury bond yield S&P Price to Expected Earnings Ratio* (dotted line) 6/ Minus -Year US Treasury Bond Yield (solid line) * Using four-quarter trailing reported earnings per share from 196 to September Then 12-month forward consensus expected S&P operating earnings per share from October 1978 through March 1994, weekly after. Note: Shaded areas are periods when S&P fell % or more. Source: Thomson Financial and Board of Governors of the Federal Reserve System. Page 34 / July 2, 6 / Strategist s Handbook

36 - Valuation: Bond Yield Figure. BOND YIELD & NOMINAL GDP -Year Government Bond Yield (percent, average = 7.1%) GDP (yearly percent change, average = 7.3%) Q This simple bond model compares the yield to the growth in nominal GDP. Source: US Department of Commerce, Bureau of Economic Analysis, and Board of Governors of the Federal Reserve System Figure 1. BOND YIELD & NOMINAL GDP* average = plus 246 basis points average = minus 269 basis points average = plus 1 basis points Q * -year bond yield minus yearly percent change in nominal GDP. Source: US Department of Commerce, Bureau of Economic Analysis, and Board of Governors of the Federal Reserve System. Page 3 / July 2, 6 / Strategist s Handbook

37 2 24 Figure 2. - Valuation: Market Cap - S&P FORWARD EARNINGS PER SHARE (weekly, Jan 1999=) 2 24 Forward earnings are moving higher for all three market-cap segments after bottoming in late Forward Earnings* S&P LargeCap S&P 4 MidCap S&P 6 SmallCap 6/ * 2-week forward consensus expected operating earnings per share. Time-weighted average of the current year s and next year s consensus forecast Figure 3. P/E RATIOS FOR S&P INDEXES* (weekly) P/E ratios for all three market-cap groups remain relatively close together S&P LargeCap S&P 4 MidCap S&P 6 SmallCap / * Price divided by 2-week forward consensus expected operating earnings per share. Page 36 / July 2, 6 / Strategist s Handbook

38 22 18 Figure 4. - Market Cap - US EQUITY MARKET CAPITALIZATION (trillion dollars) Q Market Value Total Excluding Foreign Issues S&P (weekly) Q1 6/ The total value of stocks traded in the US was $19. trillion during the first quarter of 6, down from a peak of $.2 trillion during the first quarter of. The S&P market cap is at $11. trillion Source: Standard & Poor s Corporation and Federal Reserve Board Flow of Funds Accounts. Figure. WILSHIRE INDEX (daily, 1/2/8 = 78.9) Source: Wilshire Associates. 6/ Page 37 / July 2, 6 / Strategist s Handbook

39 3 3 2 Figure 6. - S&P Sector Shares - S&P SECTORS (as a percent of total S&P market capitalization, weekly) Consumer Staples + Consumer Discretionary Health Care Financials Industrials 6/ Information Technology + Telecommunications Services Information Technology Telecommunications Services 4 3 6/ /28 Energy Utilities Materials Source: Standard & Poor s Corporation Page 38 / July 2, 6 / Strategist s Handbook

40 Figure 7. CONSUMER DISCRETIONARY (percent) Capitalization Share Earnings Share* S&P Sector Shares - INDUSTRIALS CONSUMER STAPLES INFORMATION TECHNOLOGY ENERGY MATERIALS FINANCIALS TELECOMMUNICATIONS SERVICES HEALTH CARE UTILITIES * Using consensus 12-month forward earnings forecasts. May 3 swings attributable mostly to index composition changes. Page 39 / July 2, 6 / Strategist s Handbook

41 - S&P /4/6 YTD - Figure 8. S&P LargeCap S&P 4 MidCap S&P 6 SmallCap All Sectors Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities JAN FEB MAR APR May Jul Aug Sep Oct Nov Dec 6 - JAN FEB MAR APR May Jul Aug Sep Oct Nov Dec 6 - JAN FEB MAR APR May Jul Aug Sep Oct Nov Dec 6 Page 4 / July 2, 6 / Strategist s Handbook

42 - Russell Indexes: vs Figure 9. RUSSELL vs. RUSSELL (weekly, ratio scale) 6/ Russell LargeCap Russell SmallCap RUSSELL vs. RUSSELL (yearly percent change) Russell LargeCap Russell SmallCap / RUSSELL vs. RUSSELL SPREAD (yearly percent change, basis points) Russell Outperforms Russell Underperforms Source: Frank Russell Company and Haver Analytics. 6/ Page 41 / July 2, 6 / Strategist s Handbook

43 Figure 6. LARGECAP GROWTH vs. VALUE SPREAD (yearly percent, basis points) Large Growth > Large Value Large Growth < Large Value SMALLCAP GROWTH vs. VALUE Small Growth > Small Value Small Growth < Small Value LARGECAP vs. SMALL-CAP GROWTH Large Growth > Small Growth - Russell Index: Four Styles - 6/23 6/ Large Growth < Small Growth 6/ LARGECAP vs. SMALLCAP VALUE -6 3 Large Value > Small Value 3 6/23 - Large Value < Small Value Source: Frank Russell Company and Haver Analytics. -3 Page 42 / July 2, 6 / Strategist s Handbook

44 All three of these sectors had record high forward earnings in e. M-rated Financials has been rising fairly steadily since mid-3. M-rated Health Care and U-rated Consumer Staples edged higher after flat-lining since mid-. - Relative Earnings & P/E: S&P Sectors Figure 61. S&P FORWARD EARNINGS* (1997=) S&P Index Consumer Staples Financials Health Care * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 3 Figure 62. S&P P/E RATIOS* 3 Financials P/E was 11.2 in e. It has always been a low multiple sector, trading at a discount to the market. Consumer Staples (16.7) and Health Care (.8) traded at a premium in e, but have been falling recently. 3 2 S&P Index Consumer Staples Financials Health Care * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 43 / July 2, 6 / Strategist s Handbook

45 - Relative Earnings & P/E: S&P Sectors - Figure 63. S&P FORWARD EARNINGS* (1997=) Among these cyclical sectors, M-rated Consumer Discretionary forward earnings was at a record high in e. M-rated Information Technology has stalled since late and edged up in e S&P Index Consumer Discretionary Information Technology * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. Figure 64. S&P P/E RATIOS* Both these cyclical sectors traded at premiums to the market in e. Their P/E ratios have been cut in half from the peak. Tech fell in e to 17., while Consumer Discretionary fell to S&P Index Consumer Discretionary Information Technology * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 44 / July 2, 6 / Strategist s Handbook

46 Forward earnings for these three sectors were at record highs in e. M-rated Energy forward earnings soared in 4 and, but the pace of increase has slowed recently. O-rated Industrials rising steadily since early 3. M-rated Materials remains in a cyclical upswing. - Relative Earnings & P/E: S&P Sectors Figure 6. S&P FORWARD EARNINGS* (1997=) S&P Index Energy Industrials Materials * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 3 Figure 66. S&P P/E RATIOS* 3 S&P Index In e, P/E ratios edged lower for all three of these sectors. Industrials P/E at.2 in e and has traded at a premium to the market since 4. Energy s P/E of 9.2 is the lowest P/E of the ten S&P sectors. Materials P/E of 12.1 was at an unusual premium to the market in e. 3 2 Energy Industrials Materials * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 4 / July 2, 6 / Strategist s Handbook

47 - Relative Earnings & P/E: S&P Sectors - Figure 67. S&P FORWARD EARNINGS* (1997=) Both sectors have relatively good earnings momentum since 4. Recently upgraded O-rated Telecommunication Services at a six-year high. M-rated Utilities rising at a slower pace recently S&P Index Telecommunication Services Utilities * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 3 Figure 68. S&P P/E RATIOS* 3 S&P Index P/Es are falling recently for these sectors and are now at a discount to the market. During e Telecom s P/E at 13.3 and Utilities was at Telecommunication Services Utilities * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 46 / July 2, 6 / Strategist s Handbook

48 These Consumer Discretionary industries mostly showing cyclically weak forward earnings momentum. The worst has been M-rated Auto Manufacturers, which had a negative profit margin again during Q1. Recently upgraded M-rated Auto Parts & Equipment is also earning challenged, but improving lately. Both Advertising and Publishing remain U-rated as their forward earnings have stalled. - Relative Earnings & P/E: Consumer Figure 69. S&P FORWARD EARNINGS:* CONSUMER DISCRETIONARY (1997=) Consumer Discretionary Sector Advertising Automobile Manufacturers Auto Parts & Equipment Publishing * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 4 Figure 7. S&P P/E RATIOS* CONSUMER DISCRETIONARY 4 As Auto Manufacturers forward earnings rose from close to zero, its P/E dropped to 11.9 in e from a recent high of 22.2 during February. Auto Parts and Publishing edged down slightly. Advertising had a pricy multiple of 21. during e Consumer Discretionary Sector Advertising Automobile Manufacturers Auto Parts & Equipment Publishing * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 47 / July 2, 6 / Strategist s Handbook

49 - Relative Earnings & P/E: Consumer Figure 71. S&P FORWARD EARNINGS:* CONSUMER DISCRETIONARY (1997=) 3 27 How are these fun-loving industries fairing? All are at record highs. O-rated Hotels, Resorts & Cruise Lines edged down from May s record high. O-rated Restaurants forward earnings still on solid uptrend. O-rated Casinos & Gaming rebounding from last year s plunge and back at a record high. We are raising Movies & Entertainment from market to overweight as earnings soar to new high Consumer Discretionary Sector Casinos & Gaming Movies & Entertainment Hotels, Resorts & Cruise Lines Restaurants * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts Figure 72. S&P P/E RATIOS:* CONSUMER DISCRETIONARY Among these fun-loving industries, the valuation multiples have never been so close together and are in a range between 17 and Consumer Discretionary Sector Casinos & Gaming Movies & Entertainment Hotels, Resorts & Cruise Lines Restaurants * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 48 / July 2, 6 / Strategist s Handbook

50 Among the retailers: O-rated Specialty Stores still showing good forward earnings momentum. Raising Department Stores from M- to O-rated as earnings rising at faster pace to a new record high in e. U-rated Apparel Retail rose in e, but remains in flat trend. - Relative Earnings & P/E: Consumer Figure 73. S&P FORWARD EARNINGS:* CONSUMER DISCRETIONARY (1997=) Consumer Discretionary Sector Apparel Retail Department Stores Specialty Stores * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 3 Figure 74. S&P P/E RATIOS:* CONSUMER DISCRETIONARY 3 In e, Specialty Stores had a P/E of 18.4 vs for Apparel Retail and. for Department Stores down from a peak of 18.8 during July. 3 2 Consumer Discretionary Sector Apparel Retail Department Stores Specialty Stores * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page 49 / July 2, 6 / Strategist s Handbook

51 Among these housing-related industries: M-rated Homebuilding s forward earnings peaked in February and is plunging now. Recently upgraded O-rated Computers & Electronics Retailers at a record high in e. M-rated Home Improvement Retailers on steady uptrend and also at a record high. - Relative Earnings & P/E: Consumer Figure 7. S&P FORWARD EARNINGS:* CONSUMER DISCRETIONARY (1997=) Consumer Discretionary Sector Computer & Electronics Retailers Home Improvement Retailers Homebuilding * 12-month forward consensus expected operating earnings per share. Time-weighted average of current and next year s consensus forecasts. 4 Figure 76. S&P P/E RATIOS:* CONSUMER DISCRETIONARY 4 Homebuilding s P/E remains remarkably low. It s been under since It edged up to.6 in e. At 12.2, Home Improvement Retail multiple at a record low and relatively cheap, especially compared to the 3+ readings during the late 199s. Computer & Electronics Retailers P/E was 17.8 in e Consumer Discretionary Sector Computer & Electronics Retailers Home Improvement Retailers Homebuilding * Price divided by 12-month forward consensus expected operating earnings per share using mid-month data. Page / July 2, 6 / Strategist s Handbook