Doubts that US rally will continue

US Equities

The continued problems with both the budget & trade deficits, and a weak labor market should prevent further rallies in the short term. We recommend taking profit on stocks that outperformed, and focus for laggards.

Last week we took profit on 3M Co. (MMM, $142.66, CSFB: Neutral) and Johnson Controls Inc. (JCI, $97.40, CSFB: Not rated). Since the beginning of July, 3M stock price appreciated 10.69% and Johnson Controls stock price jumped 13.98%, while the S&P 500 remained flat.

We still believe both companies are suitable for long-term investors given their low correlation with the market, their betas below 1, their strong balance sheets and the high quality of their managements. Therefore, we would take any correction in their stock prices as an opportunity to re-invest in these companies.

We recommend investing in The Allstate Corp. (ALL, $36.20, CSFB: Outperform) because stock price significantly under-performed the market. Since July 1st, ALL¡¦s stock price decreased 2.03%, compared with the insurance sector benchmark index ¡V the S&P 500 Insurance Index ¡V which gained 4.69%.

Allstate provides property-liability insurance, as well as other types of insurance in North America. In 2002, property-casualty net written premiums equalled $23.9 billion. Of the $23.9 billion, standard automobile policies accounted for 59%, non-standard automobile policies for 10%, homeowners¡¦ coverage for 21%, and other lines for the remaining 10% (source: S&P).

With Merck & Co Inc¡¦s (MRK, $53.48, CSFB: Hold) spin-off of its pharmacy benefit management (PBM) unit Medco Health Solutions Inc progressing, the predominant question about the company are the valuations of the two businesses.

Medco will be distributed in a special dividend of 0.1206 Medco shares per Merck share to shareholders of Merck as of record August 12, payable on August 19. The Medco shares had already begun trading in the grey market since August 8 and stand currently at $23.75. According to CSFB estimates, this represents a 20% discount on a EV/EBITDA basis versus its peers. While the sector on average trades at 8.7x EV/EBITDA, Medco¡¦s multiple is 7x.

Valuations in Merck appear attractive as well, since excluding Medco and taking Merck¡¦s core pharmaceutical earnings the company, expected to earn between $3.50-$3.70 in fiscal 2004, trades at a 14.5-15x P/E, assuming zero value for the Medco shares. Using analysts estimates we have on hand of Medco being worth $2.5-3.5 per Merck share, the P/E multiple becomes a compelling 13.5-14.5x.
Looking at the revenue growth potential of Merck¡¦s drug portfolio, we see these estimates as realistic. Merck should be able to achieve a 9-10% EPS growth over the next 2 years, before the loss of the patent protection of the cholesterol-lowering drug Zocor will slow down growth.

We believe that this spin off should be a positive trigger for Merck¡¦s share price, as the market will be able to value Merck for its core pharmaceutical business and will also lift the stock overhang from investors preferring not to own the PBM¡¦s shares. We do not however expect a sell-off in Medco shares after the spin off, as Medco shares will be included in the S&P 500 Index on August 19.

But we are recommending investors to switch the Medco shares into Merck, as we feel more comfortable with the near-term outlook for the pharmaceutical company as the Medco shares could see upside limited until the market assesses the company¡¦s valuations and its position in the PBM market.

Finally, coming out this week, the Housing Starts, the University of Michigan Survey of Consumer Confidence, and the Leading Indicators are the U.S. macroeconomic data for the previous month, which would drive the market.

European equities

The DJ EUR Stoxx 50 closed the week 3.6% higher at 2548.86 breaking out of the trading range which supports further upside in the short-term.

,,h Most of the indices reached their highest levels since the beginning of the year.
,,h We added two new stocks for investors with a higher risk profile: MAN and Siemens

Most of the European indices managed to reach their best levels since the beginning of the year. The DJ Stoxx 50 closed on Friday at 2548.86, which on a technical basis supports further upside in the short-term.

However, the economic data released this week shows that the Euro zone is on the verge of recession with Germany joining Italy, Switzerland and the Netherlands in reporting 2Q GDP figures reflecting that these countries slipped into a technical recession.

Euroland 2Q GDP was unchanged resulting in a 0.4% increase yoy. But with equity markets having turned more upbeat in the 2Q and confidence indicators improving in July, it could indicate that the economies have their worst months behind them, which could be reflected in the recent positive market movements.

Germany remains one of the European economies with the biggest reform potential. Besides the anticipation of tax cuts worth EUR 15.6bn into 2004, labour market and corporate reforms will be part of the plan. We added last week two stocks to our recommendation list as a play on such an anticipated recovery.

Siemens (SIE GY; EUR 52.50) ¡V a diversified manufacturing company with interests in Information & Communication technology, Medical Appliances, Automation and Power generation - and Man (MAN GY; EUR 19.77) ¡V an engineering group with exposure to commercial vehicles such as trucks and buses, printing machines and diesel engines have around a 35% sales exposure to Germany.

In addition we see the two as a restructuring play with some of their business already showing successful restructuring and some of their divisions having still further cost cutting potential. Both of them are also a play on capex recovery in Europe in 04/05.
Siemens shows good earnings momentum and with a cash flow yield of 11.5% for 03 and 10.4% for 04 looking the most promising of the European tech hardware. Despite the run-up in the shares, valuation is still reasonable with the shares trading on 15x and 12x 04 and 05 PE respectively, which is in line with their median of the last 10 years.
Man trades at a substantial discount to the European machinery sector with EV/EBITDA 7.8 vs 9.5 and PE of 8.3x vs 10.9x. In addition, Man comes with an indicative dividend yield of 3%. Man reported 2Q figures last week and they were in line with expectations.

Net income was even stronger than expected due to restructuring benefits in the truck and bus units. Printing machinery was still weak with a loss of EUR 10m. The positive effect on the share price came on the back of the good news on the truck business turnaround and better full-year guidance. The management expects to achieve ¡§an overall improvement in pre-tax earnings for the 2003 financial year¡¨ compared with EUR 219m in 2002.

We would recommend these two stocks only for investors with a higher risk appetite and with a long-term horizon.

Axa (CS FP; EUR 15.53), ING (INGA NA; EUR 18.63), Allianz (ALV GY; EUR 85.35) and UBS (UBSN VX; CHF 79.05) all surprised the market on the positive side when reporting 2Q results last week. Especially in the case of UBS we would like to point out that the second quarter was nearly perfect for fixed income as well as the increase in equity trading.

However, going forward the pattern has changed and although a potential recovery in M&A and equity revenue could make up part of it, markets should not expect the same boost from the fixed income side in the upcoming quarters for investment banks.

The European reporting season slowly comes to an end. There are some further big caps to report such as Nestle (NESN VX: CHF 289) this Wednesday, but overall the results make a pretty positive reading. On balance, there have been more positive than negative reporting surprises since May, which using as simple breadth of measure, equates to roughly 35% net positive surprises.