The TSC Streetside Chat: Jeffrey
Applegate, Lehman Brothers' Chief
Investment Strategist
By TSC Staff
Originally posted at 7:58 AM ET 6/24/00 on RealMoney.com
Goldman Sachs' Abby Cohen is Wall Street's resident
guru and DLJ's Thomas Galvin is the financial media's
latest favorite. But market professionals know Lehman
Brothers' chief investment strategist Jeffrey Applegate
deserves at least as much praise for the simple reason
that he's been uncannily right about the market for
several years running.
Applegate has consistently ranked among the top stock
pickers on Wall Street in recent years thanks to his
consistent bullishness on technology stocks. He has
been optimistic about the sector since he became
Lehman's chief strategist in 1995, and hasn't deviated
from that view since.
Having gone through the financial version of hell and
back this past spring with the group, Applegate thinks
the road ahead is a lot smoother. He is bullish overall,
but technology remains his favorite, thanks to a belief in
the sector's continued growth prospects and ability to
positively affect everything from productivity to profit
margins.
In our conversation with him, Applegate used history as
a guide to put April's frightful market action in
perspective, noting the market has had a habit of hitting
a low and then rebounding in advance of the final Fed
tightening. Recent action seems to fit that pattern, given
that the Fed last tightened on May 16, while the 10-year
bond hit its nadir on April 10 and the S&P 500 on April
14.
But whereas a prior model exists for observing the
relationship between financial markets and central bank
cycles, the so-called New Economy is uncharted
territory, he admits. Just a few years ago, for instance, it
would have been difficult to imagine a company such as
Razorfish (RAZF:Nasdaq - news), or a business model
along the lines of priceline.com's (PCLN:Nasdaq -
news), Applegate concedes.
Similarly, new divisions such as fiber optics now
account for a substantial portion of revenues at
more-established tech companies, such as Cisco
(CSCO:Nasdaq - news). He may not know what
technologies will emerge next, but Applegate is
confident industry leaders will rapidly adapt to the
changes, and that new bellwethers will emerge.
Calling the latest business cycle "extraordinary,"
Applegate thinks we are in the same bull market that
started in late 1990. Of course, there will be "risks and
bumps" along the way, he says, but going forward 12
months, stocks should do better than other asset
classes.
Critics might charge that Applegate will playing the
same old note, but those who've followed his advice in
recent years have heard the sweet sound of the cash
register ringing, over and over again.
Participating in the chat were Aaron Task, Eileen
Kinsella and Justin Lahart.
Disclosure: Both Applegate's portfolios -- the U.S.
Strategy Portfolio and the Virtual Economy Portfolio
-- are also Lehman Brothers Asset Management
products. In short, Lehman is long these stocks.
TSC: To start with, what's your synopsis of what's going
on with the market? What do you think is going to
happen?
Jeff Applegate: We're still bullish. We think the
correction is behind us. The house view is that the Fed
isn't entirely out of the picture: We're still looking for the
Fed to go another quarter-point -- not at the June
meeting, but the August one. Obviously, it's highly
dependent on what kind of data we get between now and
then. It looks to us like the second quarter is probably
below 4% in terms of local GDP, which we think puts
things below potential. That should take some of the
heat off the Fed.
Obviously, we have a fair amount of evidence now of a
slowdown. Decent CPI, PPI and Greenspan's pretty
market-friendly commentary on productivity. Obviously
he's been on that for some time, but he keeps on
extending his argument. I guess what I found interesting
about this set of comments was that where 18, 24
months ago he was fretting, "Well, we've had this
acceleration in productivity and how long will it last?"
now it's, "Well, we've made a structural change here and
it looks like this can persist for a long time." That has
enormous implications for how fast the economy can
grow, what that means for inflation, what that means for
profit margins. And profitability can improve even though
you don't have any significant pricing power.
In a cyclical sense, we do think the worst of the
correction is behind us and it's entirely conceivable that
the Fed is done. If you look at the history, and if you
look at prior periods during extended business cycles
when the Fed has been tightening to slow, but not stop
GDP [not create a recession], there were two examples
in the '60s ('62 and '64), two in the '80s ('84 and '87) and
now one in the '90s ('94-'95). If you look at history,
because markets are discount mechanisms, both the
stock and the bond market tend to trough and begin to
rebound in advance of the final Fed tightening. On
average, it's about four to five weeks in advance, and
that's been the pattern over decades. It's entirely
conceivable that the final tightening was May 16, and
the trough in the bond market was April 10, and the
trough in the stock market was April 14.
If you look what the stock market does forward 12
months from that trough, historically the forward
12-month return has been very good -- in excess of
30%. If you look at where we are at the moment from
April 14, the S&P is up about 9%. I think the markets
are in the process of reprising what they've done a whole
bunch of times. We still think we're in the same bull
market that got under way in October 1990.
"The key driver of the market is going to be
earnings growth."
TSC: In terms of a repeat of the '94-'95 scenario, what
do you say to the idea that part of what got the market
further was the fact that bond yields fell about 200 basis
points after the Fed was done tightening? They're pretty
low now and there probably isn't that much room for
them to fall further. Do you need to see much lower
bond yields to get the stock market reaccelerated?
Jeff Applegate: No. We've got forecasts that earnings
growth is going to be double-digit. We've got it slowing,
sequentially, because we've got global GDP slowing. So
we've got earnings growth going from about 20% in the
first quarter to about 16% this quarter, then 14%, then
15%. But it's still double-digit earnings growth. And next
year we have inflation down-ticking a bit. That ought to
buy you a little multiple expansion -- I don't think much,
but a little.
To me, the key driver of the market is going to be
earnings growth.
TSC: Is that concentrated in any sector?
Jeff Applegate: It's pretty pervasive. We've had a very
bullish view on profit-margin expansion. At the moment,
we're sitting around with a forecast that next year
after-tax profit margins are going to get higher than
they've ever been before. And if you look at where we are
in that pattern, because we now have the data from the
first quarter, profit margins increased by another 20
basis points. At the end of the first quarter, after-tax
margins are up to 6.8%, which is the highest in half a
century. We've basically got a view that companies can
deliver consistently above top line, because margins are
expanding. We relate that to two things: globalism and
technology, and the impact of both those things on
productivity.
All things being equal, if the Fed's either on hold or
close to being on hold, that should be OK for the stock
market. You've got a few bumps in inflation, just
because of what energy just did, but with some
disinflation next year and double-digit earnings growth,
and productivity that, if anything, looks like it's
accelerating -- that ought to be fairly decent for the
stock market.
TSC: Could you talk about why you don't see great risk
to what's going on with energy prices right now?
Jeff Applegate: I think part of it is just going to be a
slowdown here. I think the other part is you get to a
point where OPEC doesn't want alternative sources of
energy coming on stream. We're at that level now. Plus,
the outlook we have for global growth is OK, but it's not
wildly robust. We've got Europe growing around 3%, us
decelerating to below 4%. But we've still got Japan,
which is the second-biggest economy on the planet,
bumping along the bottom at 1%. We've got global
growth around 3%. That's better than it was, but still not
wildly robust. Certainly in the futures market and the
spot market, you probably have some more upside on
energy prices, just because you tend to overshoot on
the way up just like you tend to overshoot on the way
down.
TSC: You're still overweight capital goods,
communications and technology. Even the groups that
aren't technology per se, like communications services
-- you have Nextel (NXTL:Nasdaq - news) -- those are
companies that are definitely using technology like no
other companies are.
Jeff Applegate: And if you look at the capital goods
names -- Flextronics (FLEX:Nasdaq - news), Jabil
Circuit (JBL:NYSE - news), Solectron (SLR:NYSE -
news) -- those are the guys who make all the stuff that
Cisco, etc., don't make.
The tech thesis is really pretty simple. It's also pretty
compelling. We've been overweight tech since the
summer of '93, and at the time tech was 7% of the S&P.
We put in place a weight of 12%. Today, tech is about
32% of the S&P, and our weight is in excess of 50%.
The ratio in the portfolio is about the same as it was
seven years ago. Obviously the absolutes are much
higher, because the tech weighting is much higher.
The thing that originally got us there seven years ago
was simply observing what was going on with capital
goods as compared to the cost of labor. If you go back
about seven years, capital goods prices in the U.S. were
rising by about zero, and labor costs, as measured by
the Employment Cost Index, were rising by a little over
4%. Just looking at those economics, we came around
to a view where it looks like we've got in place the
economics for a pretty robust capital-for-labor
substitution process. That should mean on the corporate
side that demand for technological products ought to be
fairly consistently good, possibly for an extended period,
because if you go back earlier in this business cycle,
about 30% of cap-ex was on tech.
Fast forward to where we are today.
Overall capital goods prices are now falling by 2% a
year, and labor costs are rising in excess of 4%. So the
spread between these variables is now about 6% -- it's
actually wider than it was earlier on in this business
cycle. We would submit that the bunch of conclusions
we came to seven years ago are still valid. The
economics driving the capital-goods-for-labor
substitution process is still intact. That should mean
that workers will continue to get better tools on a
recurring basis, so that will be pretty good for
productivity. Since your increasing capital spending is
generally faster than GDP, prospects remain good for a
long business cycle -- because you're increasing
capacity as you move through the cycle. This is the
best capacity creating cycle that we've had -- you can't
find one better than this. A corollary to that is pricing
power. Since you're increasing capacity, companies
don't have a lot of pricing power, but productivity ought to
be good because of tech. What's chiefly different today,
versus seven years ago, is that 60% of cap-ex is tech,
not 30%.
I'm not an economist, but when I look at the economics,
I have a very difficult time dismantling the deflation in
capital goods. The reason you've got this deflation is the
world of semiconductors that we live in, and the big
debate in tech-land these days is not whether Moore's
law is intact, but whether it's accelerating. If you look at
labor cost in the U.S. -- given that unemployment is
bumping around 4% -- I think it's tough to make a
forecast that labor costs are going to start falling a
significant amount.
"In all the rich countries on the planet, capital
goods prices are low or falling, and labor
costs are fairly high."
Moreover, this phenomenon is not just a U.S.
phenomenon, it's a rich-country phenomenon. In all the
rich countries on the planet, capital goods prices are low
or falling, and labor costs are fairly high. Relate that
back to tech. For the S&P tech sector, 48% of sales are
from outside of the U.S.
And then of course you have the Internet. Obviously, we
couldn't foresee that in the summer of '93, nobody could,
but that's a pretty interesting metric.
No question we've got a big weight in tech, it's a highly
concentrated portfolio. But we still think that's the way
to go. These are the growth stocks of our era.
TSC: You also have the Virtual Economy Portfolio. I
guess you put that together, what, a half-year ago?
Jeff Applegate: Yes, last fall. This is the all-tech,
all-the-time portfolio. This is highly risky, and designed
as such. But it's hopefully a way to have a more direct,
albeit riskier call, on the very robust growth of the virtual
economy.
Virtual Economy Portfolio
Name
Dow Jones
Internet Index
Weighting
Lehman
Brothers
Weighting
Overweight
Infrastructure
17%
51%
Brocade Communications (BRCD:Nasdaq - news)
Broadcom (BRCM:Nasdaq - news)
Cisco (CSCO:Nasdaq - news)
EMC (EMC:NYSE - news)
Intel (INTC:NYSE - news)
JDS Uniphase (JDSU:Nasdaq - news)
Juniper Networks (JNPR:Nasdaq - news)
Lucent (LU:NYSE - news)
Nextlink Communications (NXLK:Nasdaq - news)
Qwest Communications (Q:NYSE - news)
Redback Networks (RBAK:Nasdaq - news)
Sun Microsystems (SUNW:Nasdaq - news)
Underweight
Applications &
Services
46%
32%
Broadvision (BVSN:Nasdaq - news)
Critical Path (CPTH:Nasdaq - news)
Exodus (EXDS:Nasdaq - news)
Infospace (INSP:Nasdaq - news)
Liberate Technologies (LBRT:Nasdaq - news)
Microsoft (MSFT:Nasdaq - news)
Phone Com (PHCM:Nasdaq - news)
Razorfish (RAZF:Nasdaq - news)
RealNetworks (RNWK:Nasdaq - news)
Scient (SCNT:Nasdaq - news)
Siebel (SEBL:Nasdaq - news)
Verisign (VRSN:Nasdaq - news)
Intermediary
18%
9%
Ariba (ARBA:Nasdaq - news)
CMGI (CMGI:Nasdaq - news)
Commerce One (CMRC:Nasdaq - news)
Internet Capital Group (ICGE:Nasdaq - news)
VerticalNet (VERT:Nasdaq - news)
E-Commerce
19%
6%
America Online (AOL:NYSE - news)
Priceline.Com (PCLN:Nasdaq - news)
Yahoo! (YHOO:Nasdaq - news)
Source: Lehman Brothers
table 2
U.S. Strategy Portfolio
Name
S&P 500
Weighting
Lehman
Brothers
Weighting
Overweight
Capital Goods
8%
9%
Flextronics (FLEX:Nasdaq - news)
Jabil Circuit (JBL:NYSE - news)
Solectron (SLR:NYSE - news)
Communication
Services
7%
16%
McLeod Communications (MCLD:Nasdaq - news)
Nextlink Communications (NXLK:Nasdaq - news)
Primus Telecom (PRTL:Nasdaq - news)
Qwest (Q:NYSE - news)
Sprint (FON:NYSE - news)
Vodafone AirTouch (VOD:NYSE ADR - news)
VoiceStream (VSTR:Nasdaq - news)
Technology
32%
54%
America Online (AOL:NYSE - news)
Applied Materials (AMAT:Nasdaq - news)
Cisco (CSCO:Nasdaq - news)
Comverse (CMVT:NYSE - news)
EMC (EMC:NYSE - news)
Intel (INTC:Nasdaq - news)
JDS Unifphase (JDSU:Nasdaq - news)
Lucent (LU:NYSE - news)
Microsoft (MSFT:Nasdaq - news)
Oracle (ORCL:Nasdaq - news)
Siebel Systems (SEBL:Nasdaq - news)
Sun Microsystems (SUNW:Nasdaq - news)
Yahoo! (YHOO:Nasdaq - news)
Market Weight
Energy
6%
6%
Calpine (CPN:NYSE - news)
Dynegy (DYN:NYSE - news)
Underweight
Basic Materials
2%
0%
Consumer Cyclicals
7%
3%
Home Depot (HD:NYSE - news)
Tiffany (HD:NYSE - news)
Consumer Staples
10%
3%
Clear Channel Communications (CCU:NYSE - news)
Financials
14%
6%
Citigroup (C:NYSE - news)
Morgan Stanley Dean Witter (MWD:NYSE - news)
State Street (STT:NYSE - news)
Health Care
11%
4%
Pfizer (PFE:NYSE - news)
Transportation
1%
0%
Utilities
2%
0%
Source: Lehman Brothers
This portfolio actually posed some interesting
challenges. We wanted to come up with a weighting
scheme much as we weight the other portfolio versus
the S&P, so we had to choose an index to weight it
against. We chose the Dow Jones Internet Index
because it's cap-weighted.
"The strategy at work here is basically a view
that the e-commerce space is, one, hugely
crowded, and two, full of a bunch of flawed
business models."
Then we had to come up with some kind of weighting
scheme. If you think about cyberspace at the moment,
it's a work in progress. You really don't have identifiable
economic sectors -- you will, |
