Balanced risk exposure is crucial

The best way to avoid the stock picking risk is to play the recovery via equity funds. In regard of direct investments we stick to our preference for selected cyclicals (incl. TMT) and value plays.

US Stocks

Moody's just released its latest report on US corporate credit quality, 1Q corporate bond defaults surged to a record high of US$31.8 billion. This is the most severe quarter for defaults over Moody's 80-year database. In dollar terms the amount accounts for 65% of total debt issued in 2000.

A quote from the recent WSJ 'So, if you can't figure out whether the economy is slipping into a recession or not. Don't worry, you are in good company'.

The two indices, often used to predict economic activity, currently offer exasperatingly different outlooks.

Last Wednesday, the Conference Board in New York reported the latest results for its Index of leading Economic Indicators, which is designed to forecast where the economy is headed in the next 3 to 6 months. While the index fell 0.3% in March to 108.5, the second consecutive monthly decline, the board said that pace of decline was not deep enough to prompt an economic contraction

Meanwhile, the Economic Cycle Research Institute says its monthly and weekly leading indices show a recession is no longer avoidable, for the process that leads to higher unemployment is in motion

To see where our Mr. Greespan stands, first, a history of the Federal Reserve Bank chairman tertiary education, Alan Greenspan did his undergraduate study in NYU, and studied under the renowned Geoffrey Moore known for his research work on business cycle and inflation. Next stop Columbia University for his graduate work, there during the late 40s, Mr. Greenspan also studied under Arthur Burns, who co-authored the book Measuring Business Cycles, which according to some people ranks among the great works including Keynes's General Theory.

The surprise Fed Fund rate cut last week is perhaps foreshadowing lower economic activities to come. If so, there will be more rate reductions. Lower interest rates should support the stock market, but earnings recovery will be delayed and as I have mentioned in the week before last issue of the weekly, the old economy should make a comeback before the new economy.

The most common method to evaluate the worth of a stock is to discount the future dividends or cash flow generated by the company's business. Therefore, the lower the discount factor the higher the present value of the stock price. Looking forward, despite slower growth rate, lower interest rates should provide investors with good value in stocks.

US Technology Stocks

A busy week for NASDAQ which resulted in a rebound in positive sentiment as well as price movement. On a week-on-week performance, the NASDAQ Composite Index gained 10.3% to close at 2163 last week. A slow turn in investor sentiment the week before was further encouraged by the recent Fed's midweek action that helped support continued buying. While companies that reported during the week generally met with revised expectations, quarterly sequential revenue growth were mostly significantly down, with demand visibility still limited. Nevertheless, while company executives and analysts are still trying to pierce through the thick cloud of demand uncertainty ahead, the market has moved higher and appears to be either running ahead of fundamentals (thus taking an investment 'bet'), or investors have begun pricing in a longer time horizon for their investment returns (whereby the longer-term prospects are outweighing the near-term risks).

While we believe the potential exists for profit-taking activity to take prices lower to previous low levels, we do not know with certainty if this event will occur this week or next month. Thus, until this expected profit-taking exercise is completed, we advocate adopting predefined 'profit-protect' plans and our favourite '3-tiered structured buying' strategy for all investments into the volatile technology sector.

Citing a real life example to further highlight our suggested approach, we have investor A who bought 2,000 shares of Micromuse Inc (MUSE US, $48.83, CSFB rating: Buy, CSPB MG V Buy Recommendation list) at $29.00, three weeks ago. Since then, the stock has rebounded 68% from his initial entry price. However, remembering valuable lessons learned from the year 2000, we recommend investor A to adopt the following investment actions:

Set a profit target ceiling level to lock in 120% of capital gains.

Investor A used $58,000 of investment capital to buy 2000 shares of MUSE at $29.00.

Set a profit target at $64.00.

Sell 1,000 ($58,000/$64=906.25) shares at $64.00 to effectively protect the initial capital investment.

Balance of 1,000 shares is now at 'zero cost' and is allowed to remain exposed to the usual market price volatility to ride further price appreciation in the long term.

Set a dynamic profit-protect floor level to lock in an initial 41% of capital gains.

Set a profit-protect level at $41.00 and is dynamic in the sense that the level moves higher each week whenever the stock appreciates further.

Sell 1,500 ($58,000/$41=1,414.6) shares at $41.00 to effectively protect the initial capital investment.

Balance of 500 shares is now at 'zero cost' and is allowed to remain exposed to the usual market price volatility to ride further price appreciation in the long term.


Removed KLA-Tencor (KLAC US, $52.11, CSFB rating: Buy) from our US Technology Buy Recommendation list. While KLAC reported better than expected 3Q01 results, we do not believe the forward looking demand environment will be supportive of further price appreciation in the short-term.

On a performance year-to-date basis, KLAC is up 55% and has outperformed the NASDAQ Composite index by 67%. Valuations have risen since then to 37.49x price-to-earnings, 4.54x price-to-sales and 5.37x price-to-book. Given the outstanding recovery in price from its low of $25.50 in 2000 (18-Oct-00), we believe the price upside for the stock is relatively limited. As such, we also believe the potentials for profit-taking to lead price lower towards to $37.00 grows stronger with each incremental dollar increase in the stock price from current levels. Thus, for those who own the stock, we recommend to sell the stock and look to accumulate again when price weakens back towards $37.00.

Europe

The FED rate cut added further fuel to the US equity rally that actually started one week earlier. The US optimism did not spill over to Europe to the same extent. While the S&P500 gained more than 10% in the last two weeks the Europe STOXX added 'only' 5% in the same period. Why do European markets tend to follow on the downside but not on the upside? We touched base on this point in our weekly two weeks ago and the recent earnings reports have shown that there is some truth in our remarks.

The fact that 87% of the US companies have met or exceeded expectations so far (on a revised level, though) bodes better for the ability of US companies to guide markets and stands in significant contrast to many European companies. The degree to which companies like Ericsson and Philips manage to disappoint markets affects investors' trust in the companies' forecasts. We expect the underperformance of European markets to go on during the reporting season, as more disappointments are likely to hit the market in the weeks ahead.

During 1Q01 equity markets sharply declined on the back of the economic slowdown and massive earnings revisions. The fact that stock prices do not fall much further after news of a deteriorating outlook let us assume that the markets are shifting their focus to interest rates.

The rate cut by the Fed and the commitment to do what is necessary to bring the economy back on track improves the liquidity aspect significantly. This becomes even more important if we take into account that valuations have become more attractive and cash levels of institutional and private investors have reached record-high levels. Provided the earnings outlook for Q3 and Q4 does not deteriorate much further we believe this is the time to come back to equity markets again. Even though there is no reason for euphoria the risk/return profile of equity markets has improved and we do not expect a return to the early April lows. Investments should be done with a focus on an improvement of economic growth and lower interest rates. The best way to avoid the stock picking risk is to play the recovery via equity funds. In regard of direct investments we stick to our preference for selected cyclicals (incl. TMT) and value plays.

We added TotalFina (FP FP; EUR 159.40) to our recommendation list. TotalFina is the world's number four integrated oil company. The company is traded at a 10% EV/EBITDA discount compared to the major competitors, which is not justified, in our view. TotalFina is committed to achieve the same financial performance (ROCE 16%) as the other majors on a sustainable basis by 2003. The current ROCE of 11.5% requires a tough cost cutting and restructuring programme, which is already set in place. We believe that the benefits of this programme are not fully priced yet. We see little downside risk to the oil price provided OPEC continues to stick to its discipline and the world economy does not turn in a long-term recession. Earnings estimates are still based on an average oil price below USD 25, which is too conservative. Earnings upgrades for oil stocks are likely to continue. We recommend buying the stock at current levels with 12-month price target of EUR 185.

STM (STM FP; EUR 43.08) reported an increase in net income of 43% or USD 0.38, which was slightly below consensus and earlier company guidance. Gross margin fell to 41.2% from 42.1% in the year-ago-period. The negative part of the statement was dedicated to the outlook. STM gave a rather cautious outlook for the rest of the year and cut its sales forecast for Q2 by 12%. Gross margin is expected to fall to 40-42% from 46.6% in 2Q00. We expect Q2 to be a tough quarter for STM and hence volatility to remain high. We see short-term risk to the stock if demand does not stabilise soon and/or Flash pricing deteriorates markedly. However, we are confident that STM will benefit from a recovery in the industry next year. On the basis of the reduced EPS forecast we consider it too early to buy the stock and reiterate our 'hold' rating.

Ericsson (LMEB SS; SEK 59) issued an even weaker than expected earnings report. 1Q sales declined 5% and income before ex-items and tax resulted in a loss of SEK 4.9bln (USD 490 million). Sales in the handphone unit declined by 52% and the cash outflow almost tripled compared to the year-ago-period. With sales climbing 13% and operating profits falling 4% the network unit did not convince either. Network sales now account for 87% of total sales. While the market expected these figures to be weak investors were surprised by the magnitude of the restructuring package.

Up to 12000 additional jobs will be cut, which will result in an extraordinary charge of SEK 15bln (USD 1.5bln). In addition to that Ericsson expects another operating loss of at least SEK 4.9bln in Q2. This was horrible news indeed and underlines the fact that Ericsson's problems are more than just industry related. Ericsson faces tough challenges ahead and quick and effective decisions are crucial. The market does increasingly pressure Ericsson's management to act more decisively. Rumours about a merger of Ericsson's and Sony's handphone unit and pieces of information that the management has installed a 'crisis management team' underline the urgency of the situation. It is corporate rather than operative actions that the market wants to see. We are confident that it is not a question of 'whether or not' but rather of 'when' this will happen. Very often these actions happen when newsflow is the worst. Despite the gloomy outlook and depressed levels of the stock we reiterate our 'hold' rating.

Nokia (NOK1V FH; EUR 34.65) reported earnings ahead of expectations and proved its forecast right. The company reported a 9.4% 1Q-profit increase or EPS of EUR 0.22, which was ahead of consensus. Nokia understands it like nobody in the industry to benefit from the weakness in the handphone and equipment industry. However, the current weakness forced Nokia to downgrade its sales forecast for 2001 to 20% from the 25%-35% range and its 2Q EPS to EUR 0.20 from EUR 0.22. We are looking to upgrade the stock in weakness that is likely as a result of profit taking after the strong rally over the last two weeks.