Markets to focus on valuations (page 1 of 2)

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.