Cautious on US Tech as expecting some weakness to come

US Stocks
The combination of recession, the war against terrorism, and volatile capital markets created more confusion and uncertainities than before. The market kept swinging between bouts of optimism and pessimism. The rapid military success in Afghanistan was encouraging, but the concerns about new terrorist attacks remained. We are skeptical that a strong rebound in the economy is at hand.

Various indicators are telling us there is plenty of liquidity, and return on cash is low. But both stocks and bonds are not cheap.

The current US slowdown is quite broad- based unlike previous recessions in the mid-1970s and 1980 to 1982, which were caused by higher energy prices that hurt the industrial sector, but help the oil & gas industries. The recession of 1990 to 1991, featured overbuilt real estates and the end of the cold war, which negatively impacted the defense industries.

This recession has spread from the information, computer, & telecommunication to the traditional sectors like autos, steel, textiles, furniture, paper, chemicals, tourism, & transportation industries.

This cycle has been associated with excess supply, and the deflationary effect it brings has been hurting corporate profits. This helps to explain why sharp declines in interest rates failed to stimulate growth. Earnings will take longer than expected to recover, as there is still excess capacity in the manufacturing sector. Currently, the utilization rate is only at 75%, for the technology sector is even lower at 60% with the rate for semiconductor and telecommunication equipment at 58% & 64% respectively.

Furthermore, corporate lay-off has yet to stabilize.

The current US 10-year Treasury bond is yielding at 5.10%, and is considered risk free. And the latest rally from the year lows after the Sep-11 attack has made the stock markets expensive on an earnings yield basis.

Both tech & non-tech stocks have made nice gains form the their lows in anticipation of an economy turnaround that is expected to happen sometime in the 2H of 2002. The combination of liquidity and relative valuation is the main driver for the current rally; not an improvement of the fundamentals. Further gains are possible, but the fact that the rally began from a high valuation will cap the upside, rather than prevent prices from making any gains.

This 1Q will see the reporting season for the 2001 4Q results. We do not expect profits will be what the market had hoped for. Stock selection will be the key.


New US-GAAP for amortizing goodwill

Although US equity analysts are aware of the the new US-GAAP (Generally Accepted Accounting Principles) rules for amortizing goodwill many investors might not be familiar with them. Here is a short summary:

1. Not only US companies are subject to these new rules, also foreign companies reporting according to US-GAAP (like for example ABB or Ciba SC) will have to adapt them.

2.Goodwill is calculated when companies merge or make acquisitions and basically consists of the excess price above the fair market value of net assets acquired under the purchase method of accounting. The goodwill mirrors the premium of all assets which are not in the balance sheet such as: Image, brand names, growth possibilities, market position, patents etc.

3.Under the old US-GAAP rules, this goodwill became amortized in equal installments over a certain period of time. Under the new rules (effective as of 2002) goodwill now remains "frozen" in the balance sheet and its value will be checked and revalued in yearly intervals. The idea behind this new rule is a better representation of the "fair value" of an enterprise.

However, this change of method will have some significant impacts on the valuation of equities:

A. Illusionary profits in 2002
Because of the removal of the periodical goodwill depreciation (a cost-factor, nota bene) the earnings per share of US-GAAP companies could rise substantially. Accordingly the PE ratio will fall. Although fundamentally nothing has changed, certain stocks will start to look much more attractive than before.

B. With these new rules, the meaning of the most commonly used parameter for valuing equities (i.e. the PE ratio) looses some of its shine. Due to the different treatment of goodwill and its effect on the net profit, US-GAAP companies will start to look cheaper in comparison to non- US-GAAP companies. Some analysts therefore expect the PE to be replaced by other ratios such as the P/CE. The P/CE (price/cash earnings) ratio considers the net profit before the depreciation of goodwill.

C. Due to the fact that these deprecations will not been effected in equal periodical installments anymore, and that the goodwill instead will be revalued yearly, special write-offs will lead to heavy profit fluctuations.

D. The idea to better represent the fair value of an enterprise however, also increases the possibility of tactical maneuvers. Companies could use a tactically clever moment to make the necessary write-offs in order to divert the market (and the investors) from a bad operational result.

E. If these yearly revaluations of the goodwill are not pursued consequently, the balance sheet could be blown up with hot air. If the equity (own-capital) for example is relatively small a necessary correction of the goodwill due to (for example) a change in the economic environment, could lead to insolvency.

Conclusion:
Be aware that PEs this year are not what PEs were last year (for US-GAAP companies)! Check analyst's reports for the foot-notes on goodwill and its amortization. Don't get fooled by heavy increases in net-profits.


US Technology

On a week-on-week basis, the NASDAQ Composite Index rose 4.05% to 2059 after some weakness in December.

The strong rise in technology share prices after September 11 incident wiped out hopes for a traditional yearend rally, with technology issues weakening instead on profit taking in December 2001. Looking ahead, we expected the near-term upside potential to be relatively limited (+11% on the NASDAQ Composite Index) due to the lack of positive triggers sparking heavy investor interest in technology. We expect equity prices to remain volatile as investors start focusing and reacting to company 4Q01 earnings reporting in the weeks to come.

We continue to advise investors to be careful and avoid being too aggressive in buying technology stocks at the present time. We believe there will be many opportunities ahead to buy our favourite technology stocks at lower levels. We remain cautious on technology issues given the muted expectations from company CEOs within the technology sector in the US (for the next two quarters). We expect an earnings recovery to occur mostly in 2H02 onwards. In terms of segments within the technology sector, we believe the software segment will have higher potentials of performing well ahead of hardware issues. As such, we continue to prefer software stocks in 1H02 and then look towards hardware issues only in 2H02. Mid quarter updates throughout the year should also help provide more visibility as to inventory levels and demand conditions. Until an improvement in the underlying fundamentals are confirmed, we remain cautious on technology stocks and would accumulate only on price weakness.


Europe

2001 has been the worst year for European equities in a decade. The broad European indices lost between 17% and 20% despite a 14% rally since September 11, 2001. This was the second consecutive year that European markets closed in negative territory.

European equities will very much be directed by the recovery of the global (i.e. US) economies. In the early part of the year investors should rather focus on the recovery of the economy and the development of the bond yields than on the recovery of earnings. It is our base case scenario that the US economy will show signs of recovery in the second or third quarter and believe that markets have already started to price this in 4Q01. We expect a decent equity performance between 10% (base case) and 15% (best case) based on the broad pan-European indices.

European markets should remain volatile in 2002. Hence, flexibility in terms of investment decisions will be the key for success in 2002. Investors need to be prepared to trade stocks rather than adopting a buy- & hold strategy. We will try to adopt this strategy by setting clearly defined price targets and stop-loss levels, which we will execute consistently unless we have strong reasons not to do so.

If we assume that the global economies are going to recover, bond yields will increase. An environment of recovering economies and rising bond yields favours short duration and hence cyclical sectors. Cylical stocks have been our main topic through 2001 and they are likely to remain our key focus in the first few months of the new year again. Our favourites are Lafarge (LG FP; EUR 106.90), Pechiney (PEC FP; EUR 62.60), Stora Enso (STERV FH; EUR 14.91), Syngenta (SYNN VX; CHF 86.10) and Usinor (USI FP; EUR 14.55). These stocks should be bought at current levels, as it will be too late to buy them when the economic recovery is visible in official data. They have all gained between 0.5% and 8% last week.

Apart from the cyclicals we turn more positive on the technology stocks but keep a strict focus on the industry leaders. At this point in time we are prepared to place a bet on the semiconductor stocks as fundamentals ceased to worsen. However, discipline in this group of stocks is warranted. Investors should not be misled by the recent rally and are advised to take some profits once markets move too fast.

We have turned a bit more cautious on pharmaceuticals and in particular on financials. While the financials could be negatively affected by worries about bond yields the pharmaceuticals could suffer from the relative outperformance over the past two years as funds are shifted into more economically sensitive stocks.

We have revised ratings, price targets and stop loss levels on our recommended stocks and have deleted three stocks from our recommendation list. These are Carrefour (CA FP; EUR 56.95), Ericsson (ERICB SS; SEK 60) and GlaxoSmithkline (GSK LN; GBP 17.20). Our action is not based on fundamentals but expected price performance this year. We believe that for all of them there are valid reasons to own them but it will probably take quite some time until the performance is delivered.
Alternatively we have added ASM Lithography (ASML NA; EUR 21.22) and TPG - TNT Post Groep (TPG NA; EUR 23.65) to our recommendation list.

ASM Lithography (ASML NA; EUR 21.22) is the world's biggest manufacturer of advanced photolithography systems that are needed to print integrated circuits on a chip. If the early indications about semiconductor sales prove to be sustainable chip producers will start ordering new machines soon as lead times for these products are about six months. ASML's products will enable chip manufacturers to produce cheaper, which will be the main objective of new capex. Its rich product mix will be an essential point in enlarging the customer base and improving the gross margins this year. Our short-term price target is EUR 22 and the stop loss is at EUR 17.50.

TPG (TNT Post Groep) (TPG NA; EUR 23.65) is a global provider of Mail, Express and Logistics services. While Mail (37% of revenues) is performing strongly, generating strong cash flows and reducing earnings risks it is the Express (41%) and Logistics (22%) activities that attract our attention. These two divisions are cyclical in nature and offer scope for improvement in profitability. TPG's valuation remains attractive (P/E02 19x based on CSFB's conservative forecasts that are at the low end of the range). We believe that all three units have upside potential in terms of valuation, and hence price target, if the economy recovers. Our price target is EUR 28 and the stop loss is at EUR 21.80.

2002 started well for European equity markets. The Euro STOXX 50 gained 0.93% in the first three days of trading. Volume was rather on the low side though. A glimpse at the sector performance shows that investors started the year with optimism about the economic recovery. Basic Materials (our picks are Stora Enso, Pechiney and Usinor) were the best performing stocks, gaining 4.83% followed by Technology (4.44%) and Telecom (4.18%). At the bottom we find the rather defensive sectors such as Pharmaceuticals (-3.66%), Financial Services (-3.16%) and Food & Beverage (-3.02%).

The strong rally in the economically sensitive stocks was based on a stronger than expected ISM (formerly NAPM) Index in the USA. Semiconductor stocks rallied strongly after Hynix said that it successfully increased prices for DRAM for the third time in one month. Infineon (IFX GY; EUR 26.83) led the gainers with an increase of 16.9% in the first three days of trading. Infineon remains on our recommendation list with a price target of EUR 29. Infineon reflects the most aggressive play on chip stocks among the big caps. STM (STM FP; EUR 38.80) and Philips (PHIA NA; EUR 34.07) remain the more diversified plays whereas Philips offers the best valuation and considerable restructuring potential.