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To: Les H who wrote (1193)	12/19/2001 7:46:24 PM
From: Les H	Respond to of 29592

rising market vs. deteriorating indicators worldlyinvestor.com QQQ worldlyinvestor.com

To: Les H who wrote (1193)	12/25/2001 8:15:54 AM
From: Les H	Read Replies (1) \| Respond to of 29592

MARKET EARNINGS We will make one comment that may ultimately turn into a positive one. There have been some indications that the rate of earnings warnings may be starting to decelerate. Because of the differences in dates from quarter to quarter when weekends and holidays fall, it is difficult to immediately ascertain when the seasonally adjusted pace of warnings is beginning to accelerate or decelerate. Therefore, it is too early to make a call that warnings are slowing down on a seasonally adjusted basis, but that is clearly becoming a possibility. The acid test will be the first week of January. What we need to hope for over the next week is that retail sales have a last minute surge like last year, when the weeks before and after Christmas bailed out what would have been a very week holiday shopping season. So far this year, retail sales appear to be up only a percent or two, even though the comparisons are to those very weak weeks of last year, and this is despite even greater discounts this year than last. Therefore, a gigantic surge in retail sales is desperately needed this week. We all need to do our part and shop ‘til we drop, including the days after Christmas. Have a great holiday season. (For those of you who are a glutton for punishment, our usual tables are included below.) First Call S&P500 Earnings Model The most encouraging sign is that industry analysts are cutting estimates for further out quarters than they had been before. Estimates for 1Q02 and 2Q02 were seriously cut in October and early November, but not much since. That may only be the usual seasonal pause. So far there is little movement on 3Q02 estimates. Although the pessimism has increased, it has not yet reached the over pessimism and capitulation that typically occurs before a turnaround in earnings or in the market. We continue to believe that analyst and strategist estimates for 1H02, and hence for CY02, are too high and expect meaningful downward revisions, particularly in mid December and in early January. The industry analysts currently expect earnings will be up 15.9% in CY02. However, 1Q02 earnings will surely be much lower than the $11.40 analysts are expecting. Assuming that is true, it would take a huge ramp-up in earnings from our expected $10.20 in 1Q02 to get to the industry analyst’s $14.55 in 4Q02. Our estimates for the four quarters of CY01 are based on what we believe is the best case scenario. That yields a 6.2% earnings gain for CY02 over CY01. We believe the more likely outcome would be a lesser gain, probably under 5%. 1Q 2Q 3Q 4Q CY CY S&P500 Bottom Up Earnings Estimates Bottom Up Top Down*** CY2001 12.14A* 11.69A* 10.78 10.75 45.58 43.62 CY2002 11.40 12.74 13.65 14.55 52.84** 49.35 Yr/yr gain -6.1% 9.0% 29.8% 35.3% 15.9% 13.2% Yr/yr gain using FC 10.60 estimate for 4Q01 37.3% 16.9% First Call’s Own Estimates CY2001 12.14A 11.69A 10.78 10.60 45.20 CY2002 10.20 11.70 12.10 14.00 48.00 change -16.0% 0.1% 12.2% 32.1% 6.2% * restated on basis of current S&P500 composition, etc. quarters may not add to full year because some analysts that have full year estimates do not have estimates for all quarters. * some top down providers are not excluding as many unusual items as the industry analysts are excluding. MARKET VALUATION MODELS The First Call valuation model compares the forward four-quarter P/E ratio to the inverse of the interest rate on the 10-year Treasury. There is also some interest on doing the same calculation on a trailing four-quarter basis. At close last Friday (21 Dec), the S&P500 stood at $1145 (up 2% from the $1123 at the end of the prior week) and the 10 year note interest rate at 5.09% (down 9 basis points from the 5.18% at the end of the prior week). Forward 4Q earnings through 3Q02 for the S&P500 earnings are at $48.54 (down 1% from the prior week’s $49.03). Trailing 4Q earnings through 3Q01 are at $48.10. Based on forward 4Q earnings, the current P/E is 23.6, compared to the implied fair market P/E of 19.6. That means the market is now about 20% overvalued according to the formula. However, given how much difficulty the analysts are having in keeping up with estimate cuts, that actual P/E could increase as the earnings estimates get aggressively crunched down. Based on trailing 4Q earnings, the current P/E is 23.8. However, First Call’s forward four-quarter estimate for S&P500 earnings is $44.60. The current multiple on that estimate is 25.7. If the First Call estimate proves to be more accurate than that of the analysts, then the market would be overvalued by 31%. Another way to look at valuation is to use earnings normalized for the business cycle. Based on the forward 4Q normalized earnings of $56.94, the P/E would be 20.1. That would imply the market is fairly valued if earnings are adjusted to take out the cyclical effects and look at the underlying earnings power. However, the market normally does not do that, at least not to the full extent. The current forward 4Q earnings estimate from the analysts is 14% below the forward 4Q normalized earnings (S&P500 earnings are finally spending some time below trend line after seven years of running above trend line). Furthermore, as interest rates drop to unusually low levels, the validity of the formula comes into question. The relationship of the reciprocal of interest yield to the price/earnings ratio is not a linear one. It happens to be close to linear in the range of where interest rates normally fall, but at low interest rates the formula blows up. One way to test a hypothesis based on empirical results is to look at the extremes. For example, it 10 year note yield falls to 1.00%, that would imply a fair market P/E of 100, or at a yield of 0.25% it would imply a 400 P/E. Even for Japan where the 10-year note was at 1.25% in November 2001, virtually no one would advocate the fair P/E of 80 implied by the formula. The conclusion should be that, because of the non-linear relationship, the implied linear relationship of the formula overstates the fair value P/E at low interest rates. MARKET VALUATION COMMENTS The bottom line is that we continue to believe the market is overvalued, even as prices continue to rise. Valuations are rising even faster than prices, since earnings estimates continue to fall. Although euphoria over war news as been a big factor, there is also growing sentiment that a strong recovery will be underway by mid-2002. The earlier market correction apparently did not wring out the market excesses of the late 1990’s. There seems to be an expectation of not only a smart rebound in earnings, but also that valuations will at least approach the record P/E levels of early 2000. This is particularly the case in technology sector stocks. And the fact that this kind of optimism still exists in technology is worrisome for the whole market. www1.firstcall.com\|market\|full report