Markets to focus on valuations

We recommend taking some profits at these levels. We believe that markets have a downside risk of between 5%-10% with technology stocks most at risk.


US Stocks


The Federal Reserve's latest interest rate cut leaves the best business customers of U.S. banks paying 5% interest on loans, the lowest in a generation. But what good are low rates if you can not get a loan?

In a survey of 65 members of National Association of Manufacturers' board at the end of October, more than a third said credit was tougher to obtain.
In fact, a quarterly Fed survey of senior lending officers shows banks began making it harder to get loans in late 1999 and continued tightening through 2000 and most of this year. By May, more than half the lenders surveyed (the highest level since 1990) said they were taking a tougher stance toward commercial and industrial borrowers, although that percentage dipped in the most-recent survey in August.

There are significant reasons for lenders to worry about risk, given an economy that was sputtering even before Sept. 11. Year-to-year earnings comparisons are at the worst levels in 20 years.

The most popular method of determining the 'fair-value" of the S&P500 index is earnings yield (the inverse of the P/E), and comparing it with the yield on the 10-year Treasury bond.

Let's assume that 2002 S&P500 operating earnings come in at just $45 per share (the low end of the current range of estimates) and grow at just 5% per year over the next five years (that is, in line with historical averages). Let's further assume that inflation at 2.5% level. And that the yield on the 10-year Treasury is 5.5% in 2006 (for a 3% real return). Under this set of assumptions, the S&P500 would be fairly valued at 1044 in the year 2006, or 7% below where it is trading today.

There is a possibility that (1) the consensus earnings estimates for the S&P are still too high, and (2) inflation will be slightly higher in the future. Thus, in the final analysis, as the example above illustrates, despite a series of corrections in equity valuations, stocks still may not be cheap... or even fairly valued.

Therefore, we would advise a defensive strategy and our recent stock recommendation reflects such an investment stance.


US Technology


Positive on Cisco Systems' (CSCO, $19.20, CSFB Rating: Buy). CSCO reported encouraging 1Q02 results with revenue that grew 3.5% sequentially and 31.7% year-on-year to $4.3 billion. EPS of $0.04 exceeded analyst expectations of $0.02 a share. While visibility remains limited, CSCO displayed strong management controls during the period (which we believe will continue to positively add to bottom line earnings potentials in the months ahead). Operating expenses fell 4.9% sequentially and 14.7% yoy to 2.1 billion, while Day-Sales-Outstanding fell 7 days to 24 days. CSCO also generated $1.4 billion in positive cash flows from operations during the quarter. While the company did not provide any forwarding looking comments on its businesses, the company's results helped support positive investor sentiment during the week. On a week-on-week basis, CSCO stock price rose 11%. Since the Sept-11 attacks in the US, CSCO's stock price has rebounded close to 74% (from the low on 27-Sep-01 at $11.04). While we are encouraged by CSCO's results, we do not recommend to chase the stock at current levels. Rather, we would recommend to take-profits on the stock this week and then look to accumulate again when price weakens.

Europe

While the 50bp interest rate cut by the FED was widely expected the European Central Bank (ECB and the Bank of England (BoE) managed to surprise markets by a decisive 50bp rate cut. The initial market reaction was positive but the euphoria faded out quickly on Friday. While lower interest rates are supportive for equity valuations we believe that at this point in time the main focus of investors should be on what could trigger earnings to recover. While equity markets tend to price a recovery well in advance investors need to be aware that the recent rally is built on very weak grounds. Economic news are getting worse and earnings expectations for next year remain at unrealistically high levels, i.e. valuations will be even more at risk when these forecasts are reduced unless stock prices do fall or interest rates head lower. We think that the ECB's statement does not give any hint that European economies and earnings could recover soon. In fact, the ECB press conference following the interest rate cut showed a central bank that has become more bearish on the economic growth outlook but at the same time more positive on the inflation outlook. This will cause further interest rate cuts by the ECB. However, as Mr. Duisenberg said that interest rates had now reached a level that is fully appropriate with the medium-term inflation outlook, it seems unlikely that another rate cut will happen in December. We expect interest rates to be cut by another 50bp in1Q02. Going forward, the ECB will only decide once a month on interest rates instead of the current bi-weekly mode. This is positive news, as it will increase the central bank's predictability.

Taking the fading interest rate element and the lack of earnings recovery into account, liquidity remains the driving force of this market. It is the reason why we do not see markets falling off the cliff but rather consolidate in a 5%-10% range. With bonds getting less attractive and cash yielding close to nothing investors will use any setback to increase the equity allocation. Should markets consolidate in the weeks ahead we would take a more aggressive stance in terms of our sector approach and reduce defensives in favour of technology and cyclicals with a clear focus on quality. However, this should be done with a 12-24 months investment horizon.

Aventis (AVE FP; EUR 80.80) reported a very good set of figures with core sales up 41% yoy at EUR 457 million versus expectations of EUR 429 million. The company's top three drugs along with the merger synergies from Rhone Poulenc and Hoechst once again boosted demand. Improved product mix and increased geographic concentration helped drive the gross margin up by 2.4% to 71.1%. Aventis is by far the fastest growing pharma company with good visibility and attractive valuation. We view the stock's pullback in response to the earnings report as profit-taking and would use the current weakness to buy the stock. Aventis is a safe place in a world of uncertain economic development, growing at a double-digit rate over the next few years. The stock lost 3.12% for the week.

Oil stocks were under pressure ahead of this week's OPEC meeting on November 14 and the release of the IEA report on global inventories on Monday. The price for US Crude West Texas Intermediate fell below USD 20 before recovering to USD 22.22. We believe that OPEC will reiterate its USD 18-22 price range for this winter and lower production levels. Even though the current oil price does not give much room for upside earnings, we believe that the strict capital discipline of the major oil companies does provide a high degree of earnings visibility. We continue to prefer TotalFina (FP FP; EUR 155.10) because of its attractive valuation and highest growth among the big majors.

Vodafone (VOD LN; GBP 1.7675) is expected to report earnings on Tuesday. According to a newspaper report Vodafone could announce a write-down of up to GBP 6bln on some of the acquisitions made during the telecom boom. It is not expected though that Vodafone will write-down parts of the GBP 13bln investments in 3G licenses. CSFB estimate Vodafone's 1HFY02 mobile EBITDA (valuation metric for Vodafone) to be GBP 4.6bln. We see a reasonable chance that this estimate could be exceeded as the company reported stabilising ARPU (Average return per user) in the UK, Italy and Germany and good results from Verizon Wireless. In general European mobile operators reported an increasing trend in margins. Vodafone remains our top-pick among the telecom stocks. However at the current price level valuations look ambitious and we want to await tomorrow's report to see whether earnings upgrades are in the cards.