Equity Market Strategy

As disappointing earnings pre-announcements have proliferated in recent weeks, analysts have been lowering estimates for both 2002 and 2003 earnings. The market, after months of focusing on terrorism and wrongdoing, has turned its attention to these estimate reductions. The net result is that stock prices have been adjusting downward to reflect these lower estimates. Unfortunately, this process has resulted in six consecutive weeks of market declines, capping an already dismal quarter.

With the first six months of 2002 earnings already reported the market is turning its attention to 2003’s expected results. Last quarter the consensus estimate for 2003 operating earnings was $56.00 for the S&P 500. At present, it has declined to $53.60 and is still falling. At that estimate the S&P 500 is selling at just 14.7 times earnings, the lowest multiple on forward earnings estimates we’ve seen in some time.

The real story of the market decline in the third quarter has been the fact that, of the 238 S&P 500 companies that have offered third quarter guidance, fully 123 of them, or 52%, have said they will miss expectations. This is a greater percentage anticipated to miss expectations than existed at this point in time last quarter. Moreover, the pre-announced earnings shortfalls have now extended to so-called “safety” stocks, such as certain consumer staples issues, an ominous tendency indeed.

In the wake of the severe market pullback, however, it is important to distinguish the exact nature of these earnings shortfalls. The S&P 500 is a capitalization weighted index and its earnings estimates are also capitalization weighted. Yet, the index is not weighted in the same manner as earnings are weighted in the U.S. economy. For example, technology represents 13% of the S&P 500’s market capitalization but only 3% of U.S. GDP. Thus, a shortfall in earnings for a technology company is accorded a greater weight in the marketplace than its impact on the U.S. economy. While 123 disappointing earnings announcements extend substantially beyond the technology sector, the point is that the magnitude of stock price declines in their wake may exaggerate the importance of the actual earnings shortfall within the economy itself.

At 14.7 times the estimate of earnings for 2003, the market has fallen further than we had expected. At present, its forward price/earnings ratio is at or just below the long run average price/earnings ratios at which the market has traded in the past. It has been gratifying to note that, as earnings estimates declined, the market “followed the earnings down,” meaning that the 15 times P/E ratio remained steady with the market taking points out of the stocks almost exactly corresponding to the earnings shortfall. This leads us to believe that the P/E contraction that has characterized much of the market downturn may be coming to an end.

We reiterate our strategy of emphasizing large capitalization, very high quality companies selling in globally diversified markets, dominating at least one major product line and employing sound financial controls. Unfortunately, some of these very companies have been those that have taken serious beatings in the past couple of quarters. We have examined the fundamentals of each and every one of these names and have either satisfied ourselves that the market has unduly punished a fine stock, or we have replaced that stock with another.

We also continue to emphasize the payment of dividends and look for companies with the potential to grow dividends in the future. Our orientation toward broad diversification as a measure of risk control has served common stock investors well. We have also been holding more cash than usual.

Areas of over and underweighting are modest except in one area. We are very underweighted in the telecommunications area, preferring to stay on the sidelines until the worldwide overcapacity in that industry has been worked through and its fundamentals improve. We remain somewhat overweighted in consumer cyclicals and consumer staples, areas that have either shown solid defensive characteristics or are shown to be extremely cheap.

As the economy bottoms out and begins to expand we would look to overweight the industrial and technology sectors, believing that the former will demonstrate typical cyclical improvement and the latter will resume growth that exceeds that of the S&P 500.

There are obviously risks to our scenario of gradually improving stock prices. The economy could still double dip and the industrial sector has shown particular weakness. It may be that the economic recovery will limp along in fits and starts for several quarters to come. This would delay an earnings recovery and hinder stock price appreciation. Furthermore, a resumption of terrorist activity, outside the specter of an Iraq war, could stultify the consumer, also stalling the economic recovery. Finally and importantly, our forecast assumes there will be no further contraction in P/E ratios. While we cannot make a terrific case for P/E expansion either, the market should track the 11% overall earnings increases we anticipate for 2003.