Potential for further weakness in Nasdaq

US Stocks

There is this perception that since the semiconductor industry has never experienced a decline of this magnitude, it must be the bottom. And with cheap and easy money, semiconductor is to lead the technology recovery.

Last week Goldman Sachs boarded Merrill's semiconductor train by declaring that the fundamentals are likely to strengthen in the 4Q. A bottom may have been reached, but a meaningful recovery in the 4Q may be a bit early.

More than dozen chip plants have been closed since the beginning of the year. Any increase in demand will prompt these fabs to come back on line. Then supply will increase and push back prices.

In Asia, apart from TSMC, UMC of Taiwan, and Chartered Semiconductor of Singapore's planned capacity expansion; Dongbu Group of Korea, First Silicon (Malaysia) Sdn. and Silterra (Malaysia) Sdn. will start operation this year. The top three companies are expected to account for 84% share of the world's chip production on contract this year.

Hynix Semiconductor (formerly Hyundai Electronics Industries) has shifted to making chips for other companies, as its main memory chip business remains unprofitable.

There is more capacity to come on stream in China; two new fabs are under construction in Shanghai with another two on the drawing board. This development will certainly put pressure on profit margins.

The semiconductor market depends on the consumer electronics and capital markets for survival. Not only because it supplies the economy with the primary parts for goods, but it's capital projects are so large it is only during economic expansions that they are able to secure large amounts of financing. During the past five years American consumers have been flush with cash more than ever before. This has not only driven demand for electronic goods, but has supplied a huge amount of liquidity to the capital markets.

Whether there will be a recovery will depend on the coming Christmas season. Let us hope that the consumers can hold up until then. Meanwhile, our clients can consider accumulating the following non-semiconductor stocks at current levels for a cyclical recovery of the economy:

-General Electric Co. (GE $40.80)
-Boeing Co. (BA $54)
-Exxon Mobil Corp. (XOM $40.47)


US Technology

Cautious on technology stocks. On a week-on-week basis, the NASDAQ Composite Index broke away from it's 17-week consolidation zone (between 2255 and 1915) and closed 4.5% lower at 1867. Looking into the week ahead, we believe the potentials exist for price to weaken further towards our previously identified risk level (CS Weekly, 23-Jul-01) at 1756.

Investors were spooked by Ciena Corp's (CIEN US, $18.78, CSFB rating: not covered) negative revenue guidance for the rest of the year and 2002. While the company announced sales and EPS figures that were generally in line with analyst expectations, CIEN sharply revised down forward looking earnings expectations due to the uncertain demand for telecommunications services which resulted in its customers delaying purchases and upgrades.

While investor psychology is still trapped in an 'earnings concern' state of mind, we believe that the distressed sentiment will be short-lived (ie 3-month life span) as most of the weak prospective earnings scenario has already been expected and is reflectived in present price levels. We believe sentiment will not be attractive in the short-term (3-months) and that market conditions within the technology sector will be difficult as we enter into the following October-3Q01 reporting period.

Taking a big step backwards, so as to view the overall technology sector from a bigger 'price' perspective (and taking the NASDAQ Composite Index as a representation), we view the anticipated down move as a positive event (assuming price holds above 1620) for the long term.

Why? If price continues to revisit the recent year low (6-Apr-01) and successfully holds above the 1620 level, then we effectively have confirmed a firm floor to declining prices (ie one that technical analysts define as a classical double bottom).

Is this methodology absolutely predictive? Not entirely, but it does provide a potential scenario to look forward to, which then lends a further helping hand in structuring micro-level (stock specific) investment strategies in our current volatile environment. That is, given that we have a 'bad' case scenario ('worst' case scenario is where price continues to depreciate past 1620), with a possible 5.9% (to 1756) and 13.2% (to 1620) downside risk from current levels, we should be staying out of the market at the present time so as to avoid a 'falling knife', and look to buy only when declining stock prices finds a credible floor and stabilises in consolidation.



NASDAQ Composite Index
Weekly Price Graph, Last Done 1867
(source: Bloomberg)

Taking the NASDAQ-100 Index tracking stock (QQQ US, $37.76) into consideration, and applying the 'double bottom' firm floor philosophy, we should not be buying (yet) at the current time. Instead, we should be looking to accumulate (for aggressive technology-focused investors with fresh money) QQQs only when price falls to $36.50 and $28.30. With the risk that price may continue to depreciate further, we suggest only aggressive investors adopt this strategy and buy with a minimum 6-month investment time horizon, and look to take-profits when price rebounds back to $48.00.


Europe

Investors who hoped for some stability after the 2Q01 earnings reports season were once again disappointed. Economic data such as the last Beige Book report and company statements (Bayer, Dell, HWP, Ford) do give little confidence on any recovery in the foreseeable future. This causes even brave investors to lose patience and sell stocks. To make things worse hedge funds have been very active selling the market in the last weeks. Even though we believe that the market is overreacting to these events and some stocks appear to be attractive there is no rush for investors to come back to the market for the time being. What markets need to form a sustainable bottom is the confirmation that leading indicators and earnings have bottomed. With the dismal situation in the TMT sectors and an increasing number of profit warnings from non-technology companies, the earnings recovery might well take until late 2002 to materialise.

In order to reflect the recent negative macro data, CSFB has reduced economic growth forecasts for euro-land to 1.6% (versus 1.9%) for 2001 and 1.8% (versus 2.3%) for 2002. Despite all the gloom the silver lining one can point to is sharply improving interest rate expectations. With the upside on oil prices capped and the euro strengthening the inflation threat is rapidly receding. This will be clearing the way for the European Central Bank (ECB) to finally start lowering interest rates when they next meet on August 30. The ECB might even have bigger potential to lower interest rates more aggressively than currently discounted. Taking into account the increasingly attractive valuation and the big liquidity in the market this might well provide the ground for some recovery.

With risks in individual stocks still increasing we consider funds the best place to be. Our recommended fund for Europe remains the Fidelity European Growth Fund.

Roche (ROG VX; CHF 126) reported solid 1H01 results. The company earned a net profit of CHF 2.988bln, which was unchanged to the year-ago-period but above expectations. However, taking out a one-time gain from the sale of Roche's stake in LabCorp the actual figure would be below last year's figure. The positive surprise was on the operating level where group operating profits rose by 1% versus expectations of a decline. This was entirely due to the Pharma division where sales growth and operating profit growth were stronger than expected. This improves the quality of the earnings mix and offers potential for further improvement. We believe that the worst is over for Roche. Slow but steady improvements as well as the need to come up with a strong drug story make the stock an attractive long-term investment. Roche is currently traded at a small discount to the global drug sector. We remain convinced that Roche will play a part in the ongoing industry consolidation, which could give some additional potential.

Henkel (HEN3 GY; EUR 70.81) reported a 10% increase in 2Q01 net profit. However, due to the global economic downturn and the devaluation of the Turkish Lira the company was forced to reduce 2001 forecasts. Henkel said it would at least meet last year's annual profit. This was in contrast to consensus growth of 7%. The company confirmed that the sale of the chemical unit Cognis was progressing according to plan. We continue to believe that this will allow a gradual re-rating of the stock as a pure consumer goods company. Henkel remains one of the few European big caps with a positive year-to-date performance.