Weekly comment by CSFB's Thomas Galvin:
"what the world needs now is love and liquidity. . . ."
CREDIT SUISSE FIRST BOSTON CORPORATION
Weekly Market Comment
· The definitive conclusion from the CSFB Investor Survey is that investors have very modest expectations towards profits, stocks and the Fed. More than 80% of investors expect S&P 500 earnings growth in 2001 to increase between 0% and 10%, which is highly conservative. If the Fed drops rates by 75 basis points by the end of June, the market will be pleasantly surprised.
· It is hard for us to believe in a hard landing when the biggest ticket item for consumers, new home mortgage purchase applications, is reaccelerating to a 20% level. The rebound in mortgage applications would imply a 10% to 20% rebound for stocks based on past trends.
· Three non-consensus calls for Jan 2001. First, inflation drops like a rock with the run-rate next December cracking below 2%. Second, the economy and technology fundamentals will resuscitate sooner than expected thanks to Moore’s Law. And third, investors will enjoy high-octane stock returns of between 20% to 50% in 2001.
· Favored sectors: tech, healthcare, financials and telecom. Least attractive: consumer staples, energy and utilities. Tom’s top five stocks for 2001: Nokia, Advanced Micro Circuits, Celestica, Allegiance Telecom and Morgan Stanley Dean Witter.
Investment Summary
Aside from diligently trying to survive the seasonal onslaught of Holiday parties, we found a number of data points confirming our view that the market is establishing a bottom and that we will hit a soft, not hard landing. I/B/E/S released a study showing that repeat offenders in the earnings confession camp have begun to see much smaller share price declines when the actual pre-announcement is made. The sample, which included firms such as Intel and Motorola showed on average a 23% loss in market value in pre-announcements earlier this year, but of late, the declines on bad news are averaging less than 2%. To us it suggests sellers are becoming exhausted and stocks are already discounting tough times. Six months ago, share prices fell amidst good economic news, and now the declines are statistically fewer on bad news portending some light at the end of the selling window. Also for investors worn by uncertainty, there is some solace in that more than half of the largest firms in the S&P 500 Technology sector have already pre-announced, which at least limits the flow of ongoing negative news.
Company comments from last week are exhibiting not only the sharp slowdown currently underway but also the evolution of our world to have and have-nots. Jack Welch publicly shared information regarding the sudden drop-off in short cycle orders, implying very weak demand for consumer durable products. The good news is that Alan Greenspan and Jack Welch chat frequently and therefore alarms, not holiday bells, are already booming at the Federal Reserve. Compaq and Microsoft confirmed an appropriate conclusion that the personal computer industry is quickly becoming a dinosaur as our society evolves to a wireless world. In contrast, Oracle reports November quarter results with 73% application license growth (our estimate was 63%) and database software gains of 26% (versus our estimate of 24%). Any way you slice it, they are huge growth numbers indicative of the fact that some, but not all, firms have the right product at the right time. When a credit crunch collides in an industry like technology with short product cycles, one can be sure that the natural process of creative destruction gets accelerated. An executive at Compaq would give an entirely different view of the growth opportunities in the technology industry than would an executive at Oracle. That is why God invented stock pickers, in order to identify fundamental and secular sea changes versus cyclical influences. Coming out of this credit crunch only a few tech firms will survive, but those winners will have much larger market shares and superior growth trends.
We also received interesting objective information regarding consumer and commercial spending habits. The Mortgage Banking Association reported that for the week ending December 8th, total mortgage applications rose 35% driven by a 95% increase in refinance applications. However, the more stunning tidbit was a 20% year-on-year rise in purchase applications. It is hard for us to believe in a hard landing when the biggest ticket item for consumers is reaccelerating to a 20% level. Either consumers are selling stocks and buying houses or their financial situation and confidence levels are not anywhere as dire as Wall Street would like to believe. In addition, the huge run-up in refinancings is quite likely to fatten consumer pockets in the first half of 2001 just when retailers are cutting prices and the Fed is reducing rates. Refis were a big surprise in cushioning the economy following the last extended rate hike period in 1994-1995. As shown in the top graph on page 6, a strong correlation has historically existed between mortgage applications and the S&P 500, owing to the common thread of interest rates. The rebound in mortgage applications of late would imply a 10% to 20% rebound for stocks based on past trends.
Food for thought. A survey of the National Association of Purchasing Managers (NAPM) provided color on the hot topic of capital expenditures. Manufacturing and non-manufacturing purchasing executives expect to spend 1.5% to 2% more dollars in 2001 as compared to this year. Though the absolute number is dull, one needs to look at prior forecasts versus actual results along with the mix of responses. The prior survey in May anticipated only a 1% increase in spending for 2000, but the actual is turning out to be closer to 6%, which is a major difference reflecting the overly conservative nature of capital allocators. Of those expecting to spend more next year, the average budget increase by manufacturers is 45% in 2001 and 18% for non-manufacturers. Again, those firms providing the right product at the right time will be huge winners in 2001. In oder of percentage increases, the industries expecting higher capital expenditures next year include industrial and commercial equipment and computers, electronic components and equipment, transportation, instruments, health services, construction, communication and business services. As seen in the global chaos of 1998 when profit growth for corporate America was zero, overall budgets slowed, but tech spending remained fairly robust because dollars were reallocated to productivity enhancing systems and away from lower tech areas like machine tools and assembly lines. Right now, stocks are unwilling to differentiate with a hard landing view having become consensus.
We found the results of the CSFB Investor Survey quite informative as to real time market expectations. The plurality of respondents (49%) anticipate 25 basis points of Fed rate cuts within the next six months and 36% looking for 50 basis points of reductions. If I am right and the Fed drops rates by 75 basis points by the end of June, the market will be pleasantly surprised. No major change in inflation forecasts, though incrementally, a CPI in the 1% to 2% range is regaining support. Three times as many respondents expect the 1-year Treasury bond to be 5.5% or lower twelve months ago as compared to the consensus view from April’s survey. More than 80% of investors expect S&P 500 earnings growth in 2001 to increase between 0% and 10%. In other words, conservatism is winning the day, therefore low profit gains next year is no longer new news. As for market predictions, the largest responses put the Dow Industrials between 11,000 and 12,000 in twelve months, the S&P 500 between 1400 and 1600 and the Nasdaq between 3500 and 4000. That said, as many see lower levels as they do points above these targets. The key is the dramatic change in expectations as our April survey had 47% looking for a Nasdaq between 4500 and 5500 and actually 19% looked for higher than 5500. A mere eight months has virtually turned a sky of optimism into an ocean of pessimism. Cash allocations are the highest I can recall,with 19% of respondents holding 10% to 15% cash and 15% holding 20% or more cash. Money market funds last week took in an enormous $22 billion, which in the good days equaled a month of equity mutual fund inflows. Along these cautious lines, half as many now look for stock market annual returns to average 15% to 20% over the next five years as compared to the April survey. The majority expect 10% to 15% returns. Large cap growth reigns as the leader of next twelve month returns, but the enthusiasm has clearly waned. Interestingly, 84% of investors expect the Dow Jones Internet Index to be in higher in a year. Tech and financials are also gaining favor relative to April, while energy and basic materials are viewed as unattractive. Europe exceeds Japan as the greatest risk for the USA, but the euro should move to $0.95 to $1.00 in a year. Most investors carry less than 10% of their portfolios in foreign stocks, but no big shifts are expected in 2001. Drug reform is unlikely, but tax cuts are highly probable. Consensus keys to moving stocks higher are far and away an interest rate call. The biggest change to investing going forward is lower expected returns. Last, but most fun, are the top stocks to buy and short. The long side for the grandchild account includes Cisco, Citigroup, GE, Intel, Microsoft, Nortel, Pfizer and Sun Microsystems. The short side today is Amazon, Yahoo, EBAY, AT&T, GE, Lucent, Qualcomm and Research in Motion. Needless to say, all of the shorts listed a year ago would have paid off big except for Pfizer. Thanks very much for everyone’s thoughtful responses.
In preparing a forecast for 2001 it is not without a humbling reexamination of our outlook for 2000. At this time a year ago, I had targeted a NASDAQ price target of 5000. What initially appeared spot on, eventually careened badly off course. Always a difficult task is to objectively evaluate conditions when a stock or index reaches a prescribed goal to discern if the drivers are in place to either extend the moment or exit stage left. The three factors that in hindsight were key alarm bells are interest rates, oil and over-ordering. For more than a year I have argued that the Fed was going too far with rates because the enemy of inflation would not show up due to a general lack of pricing power. We were right about inflation but wrong on the Fed’s biases as they added 75 to 100 basis points to the cost of money which was not in our crystal ball. The lack of liquidity choked off growth capital and excessively destroyed multiples. It was not surprising that dot com stocks were extinguished about as fast as they were rocketing but it was surprising that the Fed induced credit crunch took everything else down with it. Oil prices not only kept the Fed busier than they needed to be, but also greatly penalized profit margins for corporations and pinched consumer pocketbooks. A year ago we had projected oil to peak at $28 per barrel by February 2000 and then trail back to the low $20 area. It went higher and stayed higher much longer than expected particularly painful as natural gas prices soared. Insult to injury were warning signs that manufacturers were double and triple ordering electronic components along the same lines that many are now hoarding heating oil. Working down excess inventories is always tricky and as a result impatient momentum investors overnight became free-wheeling short sellers. We expect each of these three factors (rates, energy and inventories) to reverse course and become positive market drivers in 2001.
Without question, what the world needs now is love and liquidity.
Our survey and numerous meetings with investors tell us that expectations for next year are minimal. My non-consensus calls for 2001 are basically three. First that inflation drops like a rock with the run rate next December cracking below 2%. It will mean that Fed will gain huge flexibility in providing liquidity. Real interest rates are at 20-year highs just as global growth is turning down. While the consensus is calling for 50 basis points in rate reductions next year, there are 650 basis points from current levels to zero and roughly 150 basis points of available cutting room just to get real rates back toward historical averages. Second, the economy and technology fundamentals will resuscitate sooner than expected. The advent of the information age and Moore’s Law has accelerated all aspects of our economic lives. Truly excessive inventory and capacity conditions are unlikely to appear as the build to order world acts with greater speed and aggressiveness to restore supply/demand balance. The pain currently felt by production and price cuts is equally great but shorter in duration than slow downs in the past. I believe we are at least at the midpoint of the inventory surgical process with April/May bringing economic sunshine in place of prevailing darkness. Stocks must be bought in advance of the fundamental turn-up just as they should have been sold prior to the fundamental turndown. Therefore, our third non-consensus call for 2001 is high octane stock returns particularly in technology. The S&P 500 and Dow Industrials should rise about 20% and the NASDAQ and astonishing 50%. As the Fed provides liquidity, those sectors most battered by the credit crunch like tech, telecom and financials will be greatest beneficiaries as spreads reverse course and tighten, liquidity premiums will fall and P/E multiples will expand. Though most investors I meet with want to dump drug stocks now that the Election has finally ended and the NASDAQ is building a bottom, I still believe that limited profit gains in most industries next year will force investors into strong identifiable growth pockets which is best within healthcare. People paid a premium for safety in 2000 and the move to become aggressive again will take investor dollars out of consumer staples, energy and utilities. The following pages detail our sector rationale and top CSFB rated names from those industries. Our mindset is to be leaning into high beta stocks and away from defensive areas but we provide the barbell portfolios for those seeking less hand wringing and more sleep.
While I am told it is always dangerous when macro guys pick stocks, here are my top five stocks for 2001: Nokia, Advanced Micro Circuits, Celestica, Allegiance Telecom and Morgan Stanley Dean Witter. I am giving my extremely hard working team off for the Holidays, given I am such a nice guy, so our next report will be in January. Happy Holidays, Stay Bullish or Get Bullish! |
