Asset Valuation Allocation Models

July 30, 2002

Dr. Edward Yardeni (212) 778-2646 [email protected]

Amalia F. Quintana (212) 778-3201 [email protected]

Asset Valuation & Allocation Models

R e s e a r c h

/ July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

- Introduction - I. Feds Stock Valuation Model How can we judge whether stock prices are too high, too low, or just right? The purpose of this weekly report is to track a stock valuation model that attempts to answer this question. While the model is very simple, it has been quite accurate and can also be used as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after reading that the folks at the Federal Reserve have been using it. If it is good enough for them, its good enough for me. I dubbed it the Feds Stock Valuation Model (FSVM), though no one at the Fed ever officially endorsed it. On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board, famously worried out loud for the first time about irrational exuberance in the stock market. He didnt actually say that stock prices were too high. Rather he asked the question: But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions.1 He did it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of the markets exuberance. Apparently, they did so and it was made public, though buried, in the Feds Monetary Policy Report to the Congress, which accompanied Mr. Greenspans Humphrey-Hawkins testimony on July 22, 1997. 3 The Fed model was summed up in one paragraph and one chart on page 24 of the 25-page document (see following table). The chart shows a strong correlation between the S&P 500 forward earnings yield (FEY)i.e., the ratio of expected operating earnings (E) to the price index for the S&P 500 companies (P), using 12- month-ahead consensus earnings estimates compiled by Thomson Financial First Call.and the 10-year Treasury bond yield (TBY). The average spread between the forward earnings yield and the Treasury yield (i.e., FEY-TBY) is 29 basis points since 1979. This near-zero average implies that the market is fairly valued when the two are identical: 1) FEY = TBY Of course, in the investment community, we tend to follow the price-to-earnings ratio more than the earnings yield. The ratio of the S&P 500 price index to expected earnings (P/E) is highly correlated with the reciprocal of the 10-year bond yield, and on average the two have been nearly identical. In other words, the fair value price for the S&P 500 (FVP) is equal to expected earnings divided by the bond yield in the Feds valuation model: 2) FVP = E/TBY

1 http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm 2 We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table. http://www.federalreserve.gov/boarddocs/hh/1997/february/testimony.htm 3 http://www.federalreserve.gov/boarddocs/hh/1997/july/ReportSection2.htm

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 3

The ratio of the actual S&P 500 price index to the fair value price shows the degree of overvaluation or undervaluation. History shows that markets can stay overvalued and become even more overvalued for a while. But eventually, overvaluation is corrected in three ways: 1) falling interest rates, 2) higher earnings expectations, and of course, 3) falling stock pricesthe old fashioned way to decrease values. Undervaluation can be corrected by rising yields, lower earnings expectations, or higher stock prices. The Feds Stock Valuation Model worked quite well in the past. It identified when stock prices were excessively overvalued or undervalued, and likely to fall or rise: 1) The market was extremely undervalued from 1979 through 1982, setting the stage

for a powerful rally that lasted through the summer of 1987. 2) Stock prices crashed after the market rose to a record 34% overvaluation peak during

September 1987. 3) Then the market was undervalued in the late 1980s, and stock prices rose. 4) In the early 1990s, it was moderately overvalued and stock values advanced at a

lackluster pace. 5) Stock prices were mostly undervalued during the mid-1990s, and a great bull market

started in late 1994. 6) Ironically, the market was actually fairly valued during December 1996 when the

Fed Chairman worried out loud about irrational exuberance.

Excerpt from Feds July 1997 Monetary Policy Report: The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming twelve months has risen further from levels that were already unusually high. Changes in this ratio have often been inversely related to changes in long-term Treasury yields, but this years stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown. One important factor behind the increase in stock prices this year appears to be a further rise in analysts reported expectations of earnings growth over the next three to five years. The average of these expectations has risen fairly steadily since early 1995 and currently stands at a level not seen since the steep recession of the early 1980s, when earnings were expected to bounce back from levels that were quite low.

/ July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

7) During both the summers of 1997 and 1998, overvaluation conditions were corrected by a sharp drop in prices.

8) Then a two- month undervaluation condition during September and October 1998

was quickly reversed as stock prices soared to a remarkable record 70% overvaluation reading during January 2000. This bubble was led by the Nasdaq and technology stocks, which crashed over the rest of the year, bringing the market closer to fair value

II. New Improved Model The FSVM is missing a variable reflecting that the forward earnings yield is riskier than the government bond yield. How should we measure risk in the model? An obvious choice is to use the spread between corporate bond yields and Treasury bond yields. This spread measures the markets assessment of the risk that some corporations might be forced to default on their bonds. Of course, such events are very unusual, especially for companies included in the S&P 500. However, the spread is only likely to widen during periods of economic distress, when bond investors tend to worry that profits wont be sufficient to meet the debt-servicing obligations of some companies. Most companies wont have this problem, but their earnings would most likely be depressed during such periods. The FSVM is also missing a variable for long-term earnings growth. My New Improved Model includes these variables as follows: 3) FEY = CBY b LTEG where CBY is Moodys A-rated corporate bond yield. LTEG is long-term expected earnings growth, which is measured using consensus five- year earnings growth projections. I/B/E/S International compiles these monthly. The b coefficient is the weight that the market gives to long-term earnings projections. It can be derived as -[FEY-CBY]/LTEG. Since the start of the data in 1985, this earnings growth coefficient averaged 0.1. Equation 3 can be rearranged to produce the following: 4) FVP = E [CBY b LTEG] FVP is the fair value price of the S&P 500 index. Exhibit 10 shows three fair value price series using the actual data for E, CBY, and LTEG with b = 0.1, b = 0.2, and b = 0.25. The market was fairly valued during 1999 and the first half of 2000 based on the consensus forecast that earnings could grow more than 16% per year over the next five years and that this variable should be weighted by 0.25, or two and a half times more than the average historical weight. III. Back To Basics With the benefit of hindsight, it seems that these assumptions were too optimistic. But,


this is exactly the added value of the New Improved FSVM. It can be used to make explicit the implicit assumptions in the stock market about the weight given to long-term earnings growth. The simple version has worked so well historically because the long-term growth component has been offset on average by the risk variable in the corporate bond market. IV. Stocks Versus Bonds The FSVM is a very simple stock valuation model. It should be used along with other stock valuation tools, including the New Improved version of the model. Of course, there are numerous other more sophisticated and complex models. The Fed model is not a market-timing tool. As noted above, an overvalued (undervalued) market can become even more overvalued (undervalued). However, the Fed model does have a good track record of showing whether stocks are cheap or expensive. Investors are likely to earn below (above) average returns over the next 12-24 months when the market is overvalued (undervalued). The next logical step is to convert the FSVM into a simple asset allocation model (Exhibit 1). Ive done so by subjectively associating the right stock/bond asset mixes with the degree of over/under valuation as shown in the table below. For example, whenever stocks are 10% to 20% overvalued, I would recommend that a moderately aggressive investor should have a mix of 60% in stocks and 40% in bonds in their portfolio.

Bonds/Stocks Asset Allocation Model More than 30% overvalued 70% bonds, 30% stocks 20% to 30% overvalued 50% bonds, 50% stocks 10% to 20% overvalued 40% bonds, 60% stocks 10% undervalued to 10% overvalued 30% bonds, 70% stocks 10% to 15% undervalued 20% bonds, 80% stocks More than 15% undervalued 10% bonds, 90% stocks

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08-40

-30

-20

-10

0

10

20

30

40

50

60

70

80

-40

-30

-20

-10

0

10

20

30

40

50

60

70

80

7/26

ED YARDENIS ASSET ALLOCATION MODEL: BONDS/STOCKS*(for Moderately Aggressive Investor)

Stocks overvalued when greater than zeroStocks undervalued when less than zero

70/30

50/50

40/60

30/70

30/70

20/8010/90

* Ratio of S&P 500 index to its fair value (12-month forward consensus expected operating earnings per sharedivided by the ten-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after.Source: Thomson Financial.

Yardeni

- Asset Allocation -

Page 6 / July 30, 2002 / Pru

den

tial Secu

rities A

sset Valuation &

Allocation M

odels

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0475

225

375

525

675

82597511251275142515751725

75

225

375

525

675

825975

11251275142515751725

7/26

FEDS STOCK VALUATION MODEL (FSVM-1)(ratio scale)

Fair-Value Price*

S&P 500 Price Index

* 52-week forward consensus expected S&P 500 operating earnings per share divided by 10-year US Treasurybond yield. Monthly through March 1994, weekly after.Source: Thomson Financial.

Yardeni

Figure 2.

According to the Fed model, when stock prices are overpriced, returns from stocks are likely to be subpar over the next 12-24 months. Better-than-average returns tend to come from underpriced markets.

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04-40

-30

-20

-10

0

10

20

30

40

50

60

70

-40

-30

-20

-10

0

10

20

30

40

50

60

70

7/26

FEDS STOCK VALUATION MODEL (FSVM-1)*(percent)

Overvalued

Undervalued

* Ratio of S&P 500 Index to its Fair-Value (52-week forward consensus expected S&P 500 operating earningsper share divided by the 10-year US Treasury bond yield) minus 100. Monthly through April 1994, weeklythereafter.Source: Thomson Financial.

Yardeni

Figure 3.Figure 3.

- Valuation Model -


79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 042

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

7/26

S&P 500 EARNINGS YIELD & BOND YIELD

10-Year US TreasuryBond Yield

Forward Earnings Yield*

* 52-week forward consensus expected S&P 500 operating earnings per share divided by S&P 500 Index.Monthly through March 1994, weekly after.Source: Thomson Financial.

Yardeni

Figure 4.

This chart appeared in the Feds July 1997 Monetary Policy Report to the Congress. It shows a very close correlation between the earnings yield of the stock market and the bond yield. Another, more familiar way to look at it follows.

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08567891011121314151617181920212223242526

56789

1011121314151617181920212223242526

Actual Fair Jun 14 18.1 20.1 Jun 21 18.1 20.7 Jun 28 17.5 20.7 Jul 5 17.1 20.7 Jul 12 16.6 21.2 Jul 19 15.8 21.4 Jul 26 14.9 22.4

7/26

FORWARD P/E & BOND YIELD

Fair-Value P/E=Reciprocal OfTen-Year U.S. Treasury Bond Yield

Ratio Of S&P 500 Price To Expected Earnings*

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,weekly after.Source: Thomson Financial.

Yardeni

Figure 5.

The S&P 500 P/E (using expected earnings) is highly correlated with reciprocal of the bond yield.

- Valuation Model -

Page 8 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

I II III IV I II III IV I II III IV2000 2001 2002

40

45

50

55

60

65

70

75

40

45

50

55

60

65

70

75

7/26

S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS(analysts average forecasts)

For 2003For 2002For 2001

ForwardEarnings*

* 52-week forward consensus expected S&P 500 operating earnings per share. Time-weighted average ofcurrent year and next years consensus forecasts.Source: Thomson Financial.

Yardeni

Figure 6.

Expected forward earnings is a time-weighted average of current and the coming years consensus forecasts.

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 200410

15

20

25

30

35

40

45

50

55

60

65

10

15

20

25

30

35

40

45

50

55

60

65

Q1

7/25

S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED

S&P 500 Earnings Per Share________________________

Operating Earnings(4-quarter sum)

Forward Earnings*(pushed 52-weeks ahead)

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,weekly after.Source: Thomson Financial.

Yardeni

Figure 7.

Bottom-up 52-week forward expected earnings tends to be a good predicator of actual earnings, with a few significant misses.

- Earnings -


1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 200320

25

30

35

40

45

50

55

60

65

70

75

20

25

30

35

40

45

50

55

60

65

70

75

Jul

S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE(analysts bottom-up forecasts)

Consensus Forecasts__________________

Annual estimates12-month forward

Actual 4Q sum

91 92 9394

95

96

97

98

99 00

01 02

03

Source: Thomson Financial.

Yardeni

Figure 8.

Analysts always start out too optimistic about the prospects for earnings.

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 199110

15

20

25

30

35

10

15

20

25

30

35S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE(analysts bottom-up forecasts, ratio scale)

Consensus Forecasts_________________

Annual estimates12-month forward

Actual 4Q sum

80

81

82 8384

85 86 87

88

89

90


Yardeni

Figure 9.Figure 9.

- Earnings -


I II III IV I II III IV I II III IV2000 2001 2002

-20

-15

-10

-5

0

5

10

15

20

25

-20

-15

-10

-5

0

5

10

15

20

25

7/26

7/26

S&P 500 EARNINGS PER SHARE

Consensus GrowthForecasts*_______________

2001/2000

2002/2001

2003/2002

* Based on consensus expected S&P 500 operating earnings per share for years shown.Source: Thomson Financial.

Yardeni

Figure 10.

The data on consensus expected earnings can be used to derive consensus earnings growth forecasts.

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

40

45

-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

40

45

Q4

S&P 500 OPERATING EARNINGS PER SHARE*(yearly percent change)

Consensus Forecast(Proforma)*

Actual

* S&P 500 composition is constantly changing. Actual data are not adjusted for these changes. Proformaforecasts are same-company comparisions. Source: Thomson Financial.

Yardeni

Figure 11.

Earnings growth is highly cyclical.

- Earnings -


1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20040

200

400

600

800

1000

1200

1400

1600

1800

2000

0

200

400

600

800

1000

1200

1400

1600

1800

2000

7/26

FEDS STOCK VALUATION MODEL (FSVM-2)

5-year earningsgrowth weight_____________

.25

.20

.10.25.20.10

Actual S&P 500Fair Value S&P 500*

* Fair Value is 12-month forward consensus expected S&P 500 operating earnings per share divided bydifference between Moodys A-rated corporate bond yield less fraction (as shown above) of 5-yearconsensus expected earnings growth.Source: Thomson Financial

Yardeni

Figure 12.

This second version of the Feds Stock Valuation Model builds on the simple one by adding variables for long-term expected earnings growth and risk.

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 200410

15

20

25

30

10

15

20

25

30

Jul

LONG-TERM CONSENSUS EARNINGS GROWTH*(annual rate, percent)

S&P 500

S&P 500 Information Technology

Ex Information Technology

* 5-year forward consensus expected S&P 500 earnings growth. Data from 1995 based on new Global IndustryClassification Standard.Source: Thomson Financial.

Yardeni

Figure 13.

Long-term earnings growth expectations rose sharply during 1990s. They fell sharply from 2000-2002.

- New Improved Model -


1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-5

0

5

10

15

20

25

30

35

40

-5

0

5

10

15

20

25

30

35

40

Jun

MARKETS WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH*(percent)

Average = 13%

Weight market gives to long-term earnings growth________________________________________value > 13% = more than average weightvalue < 13% = less than average weight

* Moodys A-rated corporate bond yield less earnings yield divided by 5-year consensus expected earningsgrowth.

* Source: Standard and Poors Corporation, Thomson Financial and Moodys Investors Service.

Yardeni

Figure 14.

Investors have on average over time subtracted 13% of their long-term earnings growth expectations from the corporate bond yield to determine earnings yield.

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004.8

.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

.8

.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

Jun

S&P 500 PEG RATIO

P/E ratio for S&P 500divided by 5-year consensusexpected earnings growth*

Average = 1.2

* P/E using 12-month forward consensus S&P 500 expected earnings and prices at mid-month.Source: Thomson Financial.

Yardeni

Figure 15.

Historically, S&P 500 sold at P/E of 1.2 times long-term expected earnings growth, on average, with quite a bit of volatility.



1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20046

7

8

9

10

11

12

6

7

8

9

10

11

12

7/26

CORPORATE BOND YIELD(percent)

A-Rated

Source: Moodys Investors Service.

Yardeni

Figure 16.

Corporate bond yield variable in FSVM-2 captures risk that earnings will be weaker than expected.

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 060

50

100

150

200

250

300

350

400

0

50

100

150

200

250

300

350

400

7/26

CORPORATE SPREAD*(basis points)

Moodys A-Rated Corporate Bond YieldMinus 10-Year US Treasury Bond Yield

Average = 131

* Monthly through 1994, weekly thereafter.Source: Board of Governors of the Federal Reserve System and Moodys Investor Service.

Yardeni

Figure 17.Figure 17.



Figure 18.

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0425

30

35

40

45

50

55

60

65

Jul

UNITED STATES (S&P 500)

Expected EPS*(dollars)

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0475

100

125

150

175

200

225

250

275

300

325

Jul

GERMANY (DAX)

Expected EPS(euros)

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04225250275300325350375400425450475500525550

Jul

CANADA (TSE 300)

Expected EPS(Canadian dollars)

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04100

120

140

160

180

200

220

240

260

280

Jul

FRANCE (CAC 40)

Expected EPS(euros)

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04180

200

220

240

260

280

300

320

340

360

Jul

UNITED KINGDOM (FT 100)

Expected EPS(pounds)

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0420

30

40

50

60

70

Jul

JAPAN (TOPIX)

Expected EPS(yen)

Yardeni

- Global: Expected Earnings* -


Figure 19.

1995 1996 1997 1998 1999 2000 2001 2002 2003-40

-20

0

20

40

60

80

-40

-20

0

20

40

60

80

Jun

UNITED STATES

Overvalued

Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003-30

-10

10

30

50

-30

-10

10

30

50

Jun

CANADAOvervalued

Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003-40

-20

0

20

40

-40

-20

0

20

40

Jun

UNITED KINGDOMOvervalued

Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003-40

-20

0

20

40

60

80

-40

-20

0

20

40

60

80

Jun

GERMANY

Overvalued

Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003-40

-20

0

20

40

60

-40

-20

0

20

40

60

Jun

FRANCE

Overvalued

Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003-100

-50

0

50

100

150

200

-100

-50

0

50

100

150

200

Jun

JAPAN

Overvalued

UndervaluedYardeni


- Global: Stock Valuation -


Figure 20.

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0410

20

30

40

50

60

70

70

80

90

100

110

120

130

140

150

160

Jul

STOCK VALUATION MODEL

Industrial Production(1987=100)

Expected Earnings Per Share*For S&P 500 (dollars)

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 045

10

15

20

25

30

5

10

15

20

25

30

JunFair-Value P/E

Forward P/E

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0475

425

775

112514751825

75

425

775

112514751825

Jun

Fair-Value Price(ratio scale)

Stock Price Index (S&P 500)(ratio scale)

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04-40-30-20-10010203040506070

-40-30-20-10

010203040506070

Jun

Overvalued

Undervalued


Yardeni

- Global: United States (S&P 500) -


Figure 21.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003225250275300325350375400425450475500525550

75

80

85

90

95

100

105

110

115

120

Apr

Jul

STOCK VALUATION MODELExpected Earnings Per Sharefor TSE 300 (Canadian dollars)


1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 200310

12

14

16

18

20

22

24

10

12

14

16

18

20

22

24

Jun

Fair-Value P/EForward P/E

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 20032500

4500

6500

8500

10500

12500

2500

4500

6500

8500

10500

12500

Jun

Stock Price Index (TSE 300)(ratio scale)

Fair-Value(ratio scale)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003-30

-20

-10

0

10

20

30

40

50

-30

-20

-10

0

10

20

30

40

50

Jun

Overvalued

UndervaluedYardeni

* Source: Thomson Financial.

- Global: Canada (TSE 300) -


Figure 22.

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004150

200

250

300

350

85

90

95

100

105

110

Jul


Expected Earnings Per Sharefor FT 100 (pounds)


1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20047

9

11

13

15

17

19

21

23

25

7

9

11

13

15

17

19

21

23

25

JunFair-Value P/E

Forward P/E

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20041500

2300

3100

3900

47005500630071007900

1500

2300

3100

3900

47005500630071007900

Jun

Stock Price Index (FT 100)(ratio scale)


1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-30

-20

-10

0

10

20

30

40

-30

-20

-10

0

10

20

30

40

Jun

Overvalued

Undervalued

Yardeni


- Global: United Kingdom (FT 100) -


Figure 23.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 200475

100

125

150

175

200

225

250

275

300

325

90

100

110

120

Jul


Expected Earnings Per Sharefor DAX (Euros)


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004810121416182022242628303234

810121416182022242628303234

Jun

Fair-Value P/EForward P/E

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20041000

3000

5000

7000

900011000

1000

3000

5000

7000

900011000

Jun

Stock Price Index (DAX)(ratio scale)


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-40

-20

0

20

40

60

80

-40

-20

0

20

40

60

80

Jun

Overvalued

UndervaluedYardeni


- Global: Germany (DAX) -


Figure 24.

1995 1996 1997 1998 1999 2000 2001 2002 2003100

125

150

175

200

225

250

275

98100102104106108110112114116118120

Jul


Expected Earnings Per Sharefor CAC 40 (Euros)


1995 1996 1997 1998 1999 2000 2001 2002 200311

13

15

17

19

21

23

25

27

29

11

13

15

17

19

21

23

25

27

29

Jun

Fair-Value P/E

Forward P/E

1995 1996 1997 1998 1999 2000 2001 2002 20031500

2300

3100

3900

47005500630071007900

1500

2300

3100

3900

47005500630071007900

Jun

Stock Price Index (CAC 40)(ratio scale)


1995 1996 1997 1998 1999 2000 2001 2002 2003-40

-20

0

20

40

60

-40

-20

0

20

40

60

Jun

Overvalued

Undervalued

Yardeni


- Global: France (CAC 40) -


Figure 25.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 200420

30

40

50

60

90

95

100

105

110

115

Jun

Jul


Expected Earnings Per Sharefor TOPIX (yen)


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20040

50

100

150

0

50

100

150

Jun

Fair-Value P/E

Forward P/E

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20040

500

1000

1500

2000

2500

3000

3500

4000

4500

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Jun

Stock Price Index (TOPIX)

Fair-Value

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-100

0

100

200

300

-100

0

100

200

300

Jun

Overvalued

UndervaluedYardeni


- Global: Japan (TOPIX) -


1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004100

150

200

250

300

25

30

35

40

45

50

55

60

65

7/26

Jul

S&P 500 & G5 FORWARD EARNINGS

G5 Forward Earnings**

S&P 500 Forward Earnings*

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,weekly after.

** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,France, Germany, Japan and United Kingdom. Source: Thomson Financial.

Yardeni

Figure 26.

Close correlation between US and G5 profits cycle.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-30

-20

-10

0

10

20

30

-30

-20

-10

0

10

20

30

Jul

Jul

S&P 500 & G5 FORWARD EARNINGS(yearly percent change)

G5 Forward Earnings**


* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,

France, Germany, Japan and United Kingdom. Source: Thomson Financial.

Yardeni


- Earnings: US vs G5 -


79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 0470

80

90

100

110

120

130

140

150

160

10

15

20

25

30

35

40

45

50

55

60

65

7/26Jun

S&P 500 EARNINGS & INDUSTRIAL PRODUCTION



* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,weekly afterSource: Thomson Financial.

Figure 28.

Strong correlation between US industrial production and S&P 500 forward earnings.

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04-20

-15

-10

-5

0

5

10

15

20

25

30

-20

-15

-10

-5

0

5

10

15

20

25

30

7/26

S&P 500 EARNINGS & PRODUCTION(yearly percent change)

S&P 500 Forward Earnings*Industrial Production

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,weekly afterSource: Thomson Financial.


- Earnings & Output: US -


80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04-20

-15

-10

-5

0

5

10

15

20

25

30

-20

-15

-10

-5

0

5

10

15

20

25

30

7/26

Jun

S&P 500 EARNINGS & PRODUCER PRICE INDEX(yearly percent change)

PPI: Intermediate Goods


* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.

Yardeni

Figure 30.

Profits cycle is highly correlated with pricing cycles especially with the intermediate goods PPI and import prices.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003-20

-15

-10

-5

0

5

10

15

20

25

-20

-15

-10

-5

0

5

10

15

20

25

Jun

7/26

S&P 500 EARNINGS & US IMPORT PRICES(yearly percent change)

Import Price IndexS&P 500 Forward Earnings*

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial, USDepartment of Labor, Bureau of Labor Statistics.

Yardeni


- Earnings & Prices: US -


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003100

125

150

175

200

225

250

275

92

94

96

98

100

102

104

106

108

110

112

114

116

118

120

May

Jul

FRANCE: EARNINGS & PRODUCTION

Forward Earnings*


* 12-month forward consensus expected earnings per share for CAC 40.Source: Thomson Financial.

Yardeni

Figure 32.

Industrial production is key variable driving profits in France and UK.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003180

200

220

240

260

280

300

320

340

88

90

92

94

96

98

100

102

104

106

108

110

May

Jul

UNITED KINGDOM: EARNINGS & PRODUCTION

Forward Earnings*


* 12-month forward consensus expected earnings per share for FT 100.Source: Thomson Financial.

Yardeni


- Earnings & Output: Europe -


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 200320

30

40

50

60

90

95

100

105

110

115

Jun

Jul

JAPAN: EARNINGS & PRODUCTION

Forward Earnings*


* 12-month forward consensus expected operating earnings per share for TOPIX.Source: Thomson Financial.

Yardeni

Figure 34.

Japans profits cycle driven by manufacturing.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 200320

30

40

50

60

-50

-25

0

25

50

75

100

Q1

Jul

JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS

Tankan Business Conditions:Major Manufacturers(diffusion index)

Forward Earnings*

* 12-month forward consensus expected earnings per share for TOPIX.Source: Thomson Financial.

Yardeni


- Earnings & Output: Japan -


R E S E A R C H

The research analyst(s) or a member of the research analysts household does not have a financial interest in any of the tickers mentioned in this report. The research analyst or a member of the team does not have a material conflict of interest relative to any stock mentioned in this report The research analyst has not received compensation that is based upon (among other factors) the firms investment banking revenues as it related to any stock mentioned in this report The research analyst, a member of the team, or a member of the household do not serve as an officer, director, or advisory board member of any stock mentioned in this report Prudential Securities has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of 15% or more over the next 12 to 18 months. For higher risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline 15% or more over the next 12 to 18 months. For lower risk stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell. Rating distributionRating distributionRating distributionRating distribution 07/15/02 FirmFirmFirmFirm IBG ClientsIBG ClientsIBG ClientsIBG Clients BuyBuyBuyBuy 40.00% 4.00% 50.00% HoldHoldHoldHold 56.00% 5.00% 50.00% SellSellSellSell 3.00% 1.00% 0.00% Excludes Closed End Funds Any OTC-traded securities or non-U.S. companies mentioned in this report may not be cleared for sale in all states. 02-XXXX Securities products and services are offered through Prudential Securities Incorporated, a Prudential company. Prudential Securities Incorporated, 2002, all rights reserved. One Seaport Plaza, New York, NY 10292 Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such information has not been verified by us, and we do not make any representations as to its accuracy or completeness. Any statements nonfactual in nature constitute only current opinions, which are subject to change. Prudential Securities Incorporated (or one of its affiliates or subsidiaries) or their officers, directors, analysts, employees, agents, independent contractors, or consultants may have positions in securities or commodities referred to herein and may, as principal or agent, buy and sell such securities or commodities. An employee, analyst, officer, agent, independent contractor, a director, or a consultant of Prudential Securities Incorporated, its affiliates, or its subsidiaries may serve as a director for companies mentioned in this report. Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation of an offer to buy any securities or commodities mentioned herein. There may be instances when fundamental, technical, and quantitative opinions may not be in concert. This firm (or one of its affiliates or subsidiaries) may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange rate fluctuations, and limited availability of information on international securities. Prudential Securities Incorporated, its affiliates, and its subsidiaries make no representation that the companies which issue securities which are the subject of their research reports are in compliance with certain informational reporting requirements imposed by the Securities Exchange Act of 1934. Sales of securities covered by this report may be made only in those jurisdictions where the security is qualified for sale. The contents of this publication have been approved for distribution by Prudential-Bache International Limited, which is regulated by The Securities and Futures Authority Limited. We recommend that you obtain the advice of your Financial Advisor regarding this or other investments. Additional information on the securities discussed herein is available upon request.

- Introduction -- Asset Allocation -- Valuation Model -- Valuation Model -- Earnings -- Earnings -- Earnings -- New Improved Model -- New Improved Model -- New Improved Model -- Global: Expected Earnings* -- Global: Stock Valuation -- Global: United States (S&P 500) -- Global: Canada (TSE 300) -- Global: United Kingdom (FT 100) -- Global: Germany (DAX) -- Global: France (CAC 40) -- Global: Japan (TOPIX) -- Earnings: US vs G5 -- Earnings & Output: US -- Earnings & Prices: US -- Earnings & Output: Europe -- Earnings & Output: Japan -

Documents

Asset Valuation Allocation Models