NASDAQ at 1800 may encounter 'Selling' resistance on any intra-week rallies

US Stocks

When the US Treasury stopped selling the 30-yr bonds last Tuesday, at one stoke, it has done more to bring down the long term yields than the Federal Reserve Bank has in the last nine Fed Fund rate cuts. It may relieve the pain, but it will not cure it. How long will the US remain in fiscal surplus is an interesting question given last week's confirmation that the economy contracted in the 3Q, and seems to be spiraling further downwards in the October - December period. In any case, long term investors are being asked to boost the economy by accepting lower yields regardless of the risks they bear.

Whether we will have another 50 basis points cut today from the FOMC meeting has become a non-event. After all, there is a diminishing marginal utility, the additional benefits of lower cost of funds will be reduced as the interest rates decline further.

This will benefit Countrywide Credit Industries Inc (CCR $42.60), as the nation's leading service provider of mortgage refinancing. Refinancing will not necessarily put additional cash into the households; it can also reduce the term of the mortgage. Nonetheless, according to the Mortgage Bankers Association, people will take out approximately $50 billion this year, if half of the money were being spent, it will add about a quarter of a percentage point to the economic growth. But initial mortgage transaction costs will probably delay any big-ticket item purchases.

The unemployment figures last week confirm that the sales for this Christmas season would fall somewhere between bad and terrible.

It took 30 years for the total capital spending in the US to quadruple in size from 1960 to1990. In the '90s, the amount doubled within a decade and from a higher base. This feat is quite impressive, especially considering a mature economy like the US. Since hitting the peak in the 3Q of 2000, the total capital spending had declined by 8.30% y-o-y. At the same time, spending by US telecom carriers dropped by 32%.

With the large carriers like AT&T, WorldCom reeling from over expansion, the 'Baby Bells' - Qwest, Verizon, SBC, & Bellsouth were thought be the last bastion of enterprise spending. But in the latest quarterly results, cracks are beginning to show; lower earnings due to the slower economy have caught up with them.

Therefore, we remain cautious on the market; earnings and economic data would get worst before they get better. We recommend selective buying on individual counters:


• Amgen Inc. (AMGN $57.64)

• RJ Reynolds (RJR $58.19) for its net yield of 4.2%

• Countrywide Credit (CCR $42.60)

• Schlumberger (SLB $47.50)

• Southwest Airlines (LUV $16.31)

• Merrill Lynch (MER $46.80)

• United Technologies (UTX $54.28)

• Applied Biosystems (ABI $30.35)

• Waste Management (WMI $24.80)

Microsoft Corp (MSFT $61.40) will learn by today how many states would want to pursue the antitrust case. Reiterate to sell into this development as MSFT has appreciated 20% from its September 11 low. The states of California and New York have already expressed that they will not join the accord. They wanted changes made to specific points, and are expected to raise their objections to the US District Judge. In doing so, it will throw the case into a legal limbo. The settlement requires Microsoft to host three independent experts who will monitor whether MSFT conforms to the terms of the agreement. May we suggest Scott McNealy of SUN Microsystems, Larry Ellison of Oracle Corp., and Steve Case of AOL.

US Technology

On a week-on-week basis, the NASDAQ Composite Index retraced 1.3% to fall back to 1745. For the week ahead, we believe the 1800 level will be a short-term upside barrier where price will potentially encounter 'Selling' resistance on any intra-week rallies.

Investor sentiment for the week will be dominated by Cisco Systems' (CSCO, $17.26, CSFB Rating: Buy) earnings release this evening. While CSCO's CEO provided supportive comments back in October where Mr. Chambers commented that he was 'very comfortable' with analysts' present earnings expectations for the company's Oct-1Q02 results, investors will be focusing on any forward-looking commentaries from the company's management. Since the Sept-11 attacks in the US, CSCO's stock price has rebounded close to 50%. In terms of price targets, we would look to lock-in a portion of profits at $20.00, and Buy to accumulate the stock again if price weakens back to $15.00.

Zero-Cost Averaging. Many investors have widely employed the micro structure stock investment approach known as the Cost Averaging Down strategy (ie to buy more at lower price levels so as to reduce average purchasing price). However, with technology equity price movements expected to remain volatile in the weeks ahead, we would like to share (again) a little known alternative strategy called Zero-Cost Averaging. This strategy aims to proactively capitalise on volatility to build an absolute return long-term equity portfolio with no investment capital risk for the investor.

How does it work? Well, taking CSCO as an investment example, and assuming we were aggressive (and lucky enough) to have bought 2000 shares of CSCO at $14.00, and have set initial profit-targets at $18.00 and $20.00, then a zero-cost averaging strategy would have the following scenario structure:

Trade No 1a: Initial Investment in CSCO at $14.00:
Buy: 2000shs x $14.00 = $28,000
Capital at risk: = $28,000
Breakeven target: $28,000 / $18.00 = 1600shs*

Trade No 1b: Profit-taking on CSCO at $18.00:
Sell: 1600shs x $18.00 = $28,800
Capital at risk: = $0.00
Remaining exposure: 2000shs-1600shs = 400shs

Trade No 2a: Reinvest in CSCO at $15.00:
Buy: 2000shs x $15.00 = $30,000
Capital at risk: = $30,000
Breakeven target: $30,000 / $20.00 = 1500shs

Trade No 2b: Profit-taking on CSCO at $20.00:
Sell: 1500shs x $20.00 = $30,000
Capital at risk: = $0.00
Remaining exposure: (2000-1500)+400 = 900shs

The net effect is that the investor will have 900 shares of CSCO and no investment capital at risk! The 900 shares of exposure to CSCO is then basically 'sponsored' by the market. The investor can now reallocate his freed-up investment capital ($28,000) to other stock candidates and repeat the same procedure.

This strategy is effective as it enforces investment discipline before any buying decisions are made. That is, it address the following common questions after an investor has selected an investment candidate:

(1) how many shares of CSCO do I buy?
(2) what should I do when price appreciates?
(3) how many shares of CSCO do I sell?
(4) should I buy again at lower levels?
(5) how many shares of CSCO do I buy again?
(6) am I overly invested in the stock?
(7) how much investment capital do I have left?

While is strategy is not the 'holy grail' to guaranteeing capital gains when investing in technology stocks, the structure will help investors reduce risk when price rallies in his favour and yet remain invested within a volatile equity pricing regime.
*(rounding off to the nearest 100)




Europe

While we feel confirmed in our cautious scenario by the weak economic data (NAPM, consumer confidence, unemployment figures) out of the USA we are as surprised about the resilient response of the equity markets. One can argue that markets take a view for a recovery some time in the second half of next year. We continue to feel that the full impact of the terrorist attacks is not visible in the economic figures yet. Economic data could deteriorate further (i.e. a deeper 'V' shape) before they recover, which could well be later than currently assumed.

We doubt that markets would be prepared to remain as foresighted on such a development as equity markets are not necessarily cheap at these levels. The interesting part in looking at equity valuations on both sides of the Atlantic is that, according to CSFB research, there is a stark contrast between the US and European equity markets. US equities currently trade on implied growth rates of 11% versus just over 8% in continental Europe and 7.3% in the UK. While we seriously question whether this optimism is justified given the outlook for the US economy Europe might be a better place on a relative basis (though not necessarily on a absolute basis).

It is important to note that we are not bears when it comes to medium-term (12-18 months) investments but at this point in time we would advise investors not to jump on the bandwagon and wait for the consolidation to develop further. We would use weakness to build up positions in a combination of reliable earnings generators (pharma) and economically sensitive stocks (construction, materials, paper and selective technology stocks). In contrast to defensive stocks European cyclicals remain attractively valued discounting on average about 6.5% less growth over the next 10 years than US counterparts. The record low interest rates should act as a support to markets. While this week's likely rate cuts should be widely discounted by the market the focus will be on any hint about further possible rate cuts.

We believe that the US government's decision to stop selling 30-year bonds will have positive implications on construction stocks such as Lafarge (LG FP; EUR 95.20). The elimination of the 30-year bonds will increase demand for 10-year bonds driving down yields and boosting mortgage refinancing. In addition to this positive development Lafarge reported much higher synergy benefits from the acquisition of Blue Circle between 2002 and 2004 (see weekly of 29.10.01). The stock came under pressure last week on the back of a profit warning of CRH, which blamed weakness in the US residential building industry. We think Lafarge's share price reaction was overdone as the company is more geared towards infrastructure projects. We would use the current weakness to buy the stock with an investment horizon of 12-18 months and a price target of EUR 125).

Serono's (SEO VX; CHF 1295) earnings report disappointed the market as the company reported a net profit of USD 63.8 million versus expectations of USD 71 million. Rebif (Multiple Sclerosis) performed excellently gaining 47% while sales of the infertility drug Gonal-F increased only 3.4%. However, the fact that Serono had to reduce its earlier 20% net growth target for this year to 6-8% due to lower interest rates and an additional USD 30 million investment in Rebif to prepare for the USA launch caught the market by surprise. Only a week earlier Serono declined the rumours about a profit warning. Serono's management's handling will have negative implications for investors' confidence. However, adding 6-8% to last year's net profit of USD 301 million results in a range of USD 319-325 million. If the USD 30 million for the Rebif launch are taken into account the net profit would be between USD 349 and 355 million, which would not be too far away from the USD 360 million or 20% net profit growth. Even though the additional investment in Rebif is a surprise we consider it a sensible decision and are not too worried about the net shortfall compared to earlier estimates. We would use the current weakness as a buying opportunity with a conservative target of CHF 1500.

Overall earnings reports provide little positive surprises. Companies such as Alcatel, Deutsche Telekom, Serono and BBVA all reported earnings below expectations. Most of the companies point to 4Q01 earnings to deteriorate further and companies such as Alcatel (10000 jobs) and Deutsche Bank (4500 jobs) announced further job cuts. All this points to our assumption that earnings will have to deteriorate further before they get better. While the market assumes this we expect the actual figures to disappoint and lead markets lower. This weakness should be used to increase the equity allocation.