Focus on large caps

US Stocks

When the Federal Reserve Bank first initiated its tightening policy back in June 1999, the S&P500 Index, despite correcting in the subsequent increases, managed to hit a high in March '00, shortly before the Fed's sixth and last increase of 50 basis points. There was even an attempt to retest the high in August before the S&P500 finally succumbed to the earnings decline and the eventual correction ensured.

From an earnings perspective, growth did not peak till the second quarter of 2000, and perhaps that is why the market index continued to power forward during the early stage of the Fed tightening. In a sort of reversed mirror image, the S&P500 rallied and went down again as the Fed first reduced the Fed Fund rate by 50bp. It may continue to remain weak as the index had remained strong during the early stage. The key here is for the Fed to keep on lowering interest rates so that the earnings decline would bottom and reverse itself.

The market has corrected from its extreme valuation, and current levels are closer to fair value. The potential for a spending retrenchment is a greater threat; an economy must have increasing consumption to support higher earnings if higher equity prices are to be justified and sustainable. Although the stock market is no longer at an overvalued extreme, but there are still earnings worries. If growth remains weak, real earnings growth will need a year or more to recuperate.

Rate cuts of over 100 basis points as implied by the credit market will certainly have a positive effect on the equity markets. And the monetary environment has just begun to turn easy. Now is the time to position the investments for an improvement in earnings in the next 6 to 9 months.

The initial focus should be on the large caps (see table below); some of these stocks are at attractive valuations. Then the beaten down quality tech stocks should be considered on a selective basis.

US Technology Stocks

In the year 2000, the NASDAQ Composite Index posted a crashing performance of -39.3%. The Internet "dot.com" bubble imploded, and optimistic profit exuberance degenerated into free-fall panic. Investors have over-reacted to concerns of earning decline. We believe the scenario of a bottomless pit to declining stock prices is but a shadowy dream. Why? Because, the growth engine of the Internet continues to roar. As the "hunger" for information is insatiable, the Internet will remain the mainstay communication vehicle.

Demand for Internet access continues to grow, as evidenced by AOL's recently announced growth in subscribers. In less than 49 days, AOL added one million subscribers in November (at nearly the same rate as in October) and now has more than 26 million AOL-branded users.

With the Internet adoption rate increasing, the demand for access speed will continue to grow and subsequently, attract more Internet-related (software and hardware) applications and utility resources. Demand is currently pent up and access is constrained. While the broadband infrastructure buildout will continue, the focus for the year ahead will be maximising efficiencies over the existing backbone network (to derive more value from every dollar invested).

While investors are struggling to understand the new virtual economy game, the lessons derived from 2000, which should aid us in 2001, points to 2 traditional success philosophies; (a) strategy and (b) focus.

What is our strategy? Are we to fully invest funds into technology or do we apprehend risk by diversifying our sector exposure?

What is our investment time horizon? Do we pile up our capital into a 1 week investment return scenario, or do we spread out our investments into multiple time horizons?

What is our expected return? Shall we look forward to an indefinite return or shall we peg a large portion of our capital gains to a predefined amount?

While we prepare happily for up days where accelerated rising prices promise the rewards of jubilant wealth, have we set aside contingency plans for a contradictory outcome?

Is our strategy overly aggressive or excessively conservative? Have we recognised the inherent price volatility and will our hearts be at peace with the decisions?

While stock prices soar towards the sky or plunge deep into the abyss, are we still focused on our investment strategy? .

Do we scramble to buy stocks on up days (sell vehemently on weak days) or do we remain focused on selected top tier stocks?

While there is no added value in crying over spilt milk, rich rewards are in store for those who learn from past follies.

We maintain that the 1H01 will be plagued with high volatility, which could present many profitable opportunities or many hidden poverty traps. Rather than "trade" in a volatile environment, we recommend to invest for more profitable (and less volatility risk) 2H01 returns.

We continue to like stocks in the fiber optic component-related segment (Nortel Networks, NT $33 1/16), B2B applications space (Commerce One, CMRC $18 9/16) and Networking arena (Micromuse Inc, MUSE $49 5/8).

Europe

What a start to the new year! It all started with a massive sell-off followed by an even stronger rally on the back of the FED's interest rate cut. Investors might wonder whether it is time to buy now. By lowering interest rates drastically the FED has sent a very strong signal to the market that it is committed to avoid a recession. The Fed expressed its determination to lower rates further if economic conditions warrant. Hence we believe that the FED's action has limited the downside risk of markets significantly. However, even though equity markets rallied in most of the periods following the first rate cut and even more after the second step we believe it is still early days to cheer. Firstly, the US economic data are still unclear, which makes it difficult to divine the underlying health of the US economy (and hence the global equity markets). Secondly, the unexpected rate cut leaves the impression that the economy is cooling down faster than expected and possibly foreshadows a difficult fourth quarter for profits.

Given the tug of war between interest rates and earnings we believe that the market's focus will shift to earnings over the next month. The upcoming earnings reports might cause some volatility. However, in terms of market levels we believe that we have seen the lows with Tuesday's closing levels. Hence, we would use the coming weeks of volatility to implement our strategy of increasing the TMT and cyclical allocation and reducing the defensives.

We continue to believe that financials and technology shares are the best way to play lower interest rates. The time to invest in cyclicals might not be far away either, now that short-term rates are falling. European retail stocks also look attractive as we expect consumption in Europe to remain at healthy levels (lower tax rates, stable job situation etc.). We would advise to slowly lighten up overweights in sectors such as pharma and food. These two sectors experienced heavy losses of 11.5% and 8.1% resp. for the week. Defensive stocks are not so much threatened by earnings but by high valuations and tremendous money flows out of these sectors. As markets have entered a very tricky situation investors should focus on high quality stocks. A switch of second-tier stocks into best quality can still be done at these depressed levels. Companies with a good balance sheet, convincing business model and leading products will be the winners in the next rally.

As of now, we see banks with investment banking exposure as the best risk/reward play on lower interest rates. Valuations are attractive and the downside risk is limited. Our prime choices are UBS (UBSN SW; CHF 279) and ABN Amro (AA NA; EUR 25.55) as higher-risk exposure.

In order to get a slightly more defensive element in a portfolio we added Carrefour and Henkel to our recommendation list and deleted Swisslog and Vivendi Universal. Even though fundamentals are intact we believe that in the case of the latter two it will take some time to outperform markets again.

Carrefour (CA FP; EUR 66.05) came down a long way over the last few months on the back of declining sales figures due to shop conversions in Spain, mad cow disease concerns and the global economic slowdown. We believe that most of the negative news is priced at this level and Carrefour offers attractive valuation and good management. December consumer confidence figures in France rose to a new high last week and same-store sales at hypermarkets rose for the first time in three. Carrefour is not exposed to the strengthening Euro due to its high exposure to Europe (85% of sales) and better outlook for consumption in Europe. We expect Carrefour to reach a level of EUR 85, which is an upside potential of approx. 29%.

Henkel (HEN3 GY; EUR 69.11) is a valuation and consumer play. The company generates about 77% of sales in detergents, body care & toiletries (Schwarzkopf) and cosmetics. The remaining 23% comes from its consumer chemical unit Cognis. Despite the high exposure to consumer products Henkel is valued much more like a chemical stock than a consumer goods stock such as L'Oreal, Wella, Unilever etc. Its discount to its direct peers is close to 50%, which we feel is unwarranted. Henkel's management is committed to find a solution for Cognis. We expect this to happen in Q2 or Q3 of 2001. We believe that a full disposal is more likely now and if cyclicals experience a rally the timing could be earlier rather than later. This would lead to a re-rating in the stock closer to its direct peers. Our target for Henkel is EUR 82 or 24% from current levels.


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This document has been prepared solely for information purposes and for the use of the recipient. It does not constitute an offer or an invitation by or on behalf of Credit Suisse to any person to buy or sell the security. Any references to past performances is not necessarily a guide to the future. The research and analysis contained in this publication have been procured by Credit Suisse and may have been acted on before being made available to clients. For further information, please contact your investment advisors or Investment Consulting.