We believe there is a potential for earnings downgrades in 03 (page 1 of 3)

US Markets
• Recommendation update

Since October 10th, diversified financials have outperformed the market. The S&P 500 Diversified Financials index had a total return of 28.50%, while S&P 500 had a total return of 15.98%. Concerns related to headline risk and high consumer credit seem to have faded in investors' minds, hidden by the falling unemployment rate. However we would be more cautious, believing these risks remain, and we would not recommend the sector. Firstly we believe that the outlook for U.S. economy remains uncertain. Retail sales were mixed in October. The Department of Commerce reported that U.S. retail and food services sales fell to $301.7 billion, virtually unchanged from September, but down 0.7% y-o-y and below consensus forecasts of a 0.2% decline. One the one hand, motor vehicle sales declined 1.9% m-o-m due to the lack of new incentives offered by auto dealers. On the other hand, retail sales less autos rose 0.7% in October. The sudden spell of cold weather across the U.S. gave clothing sales a boost of 4%. Gasoline stations also did well (1.5%), and non-store retailers increased 1.4%. Secondly we think consumer credit should weaken in the near-term as banks tighten their credit standards (source: the Federal Reserve's "October 2002 Senior Loan Officer Opinion Survey on Bank Lending Practices"). 10% of banks surveyed tightened credit standards for approving mortgage loans, 15.2% of banks tightened credit standards for approving applications for credit cards and 14.9% of banks tightened credit standards for approving consumer loans. It is important to note none of the banks surveyed eased credit standards. We believe this is a good move for credit quality and competitive intensity. Finally we think it likely that several periods of profit taking should occur, putting pressure stock prices.

We maintain our hold recommendation and long-term view on Citigroup Inc. (C, $38.54, CSFB: Outperform). We believe Citigroup will remain under pressure from negative news, eroding investors' confidence. Several lawsuits have still not been resolved (e.g. Enron, WorldCom) and conflicts of interests between banking and research businesses could bring further surprises. On the business side, we are positive on the company. Product mix should protect company's earnings from volatility.

Mortgage companies should maintain good momentum, even if rising delinquencies in this segment could pose problems for some companies. We would rather focus on companies with well-diversified businesses, maintaining our buy recommendation on Countrywide Financial Corp. (CFC, $51.45, CSFB: Not covered). The bulk of its earnings come from mortgage origination fees and other fee income, which made up over 70% of 2001 pre-tax earnings, while earnings from mortgage-related investments were 28% in 2001.

The Nasdaq Composite Index saw a rally over the second half of the week, as Hewlett-Packard (HPQ, CSFB: Neutral) issued positive guidance during its earnings release. While we remain cautious on the outlook for the computer related stocks like Hewlett-Packard, we do not share management's optimism, especially since the numbers it reported wee more the product of cost cutting than top line growth.

But in order to ride the rally in the technology stocks, which we believe still has some momentum left in it, we recommend the small cap entertainment software maker THQ Inc. (THQI, $17.95, CSFB: Outperform).