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
Page 2 / 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.
Page 4 / 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,
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 5
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 -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 7
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 -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 9
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
Source: Thomson Financial.
Yardeni
Figure 9.Figure 9.
- Earnings -
Page 10 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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 -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 11
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 -
Page 12 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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.
- New Improved Model -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 13
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.
- New Improved Model -
Page 14 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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* -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 15
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
Source: Thomson Financial.
- Global: Stock Valuation -
Page 16 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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
Source: Thomson Financial.
Yardeni
- Global: United States (S&P 500) -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 17
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)
Industrial Production(1997=100)
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) -
Page 18 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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
STOCK VALUATION MODEL
Expected Earnings Per Sharefor FT 100 (pounds)
Industrial Production(1995=100)
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)
Fair-Value(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
Source: Thomson Financial.
- Global: United Kingdom (FT 100) -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 19
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
STOCK VALUATION MODEL
Expected Earnings Per Sharefor DAX (Euros)
Industrial Production(1995=100)
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)
Fair-Value(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
Source: Thomson Financial.
- Global: Germany (DAX) -
Page 20 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
Figure 24.
1995 1996 1997 1998 1999 2000 2001 2002 2003100
125
150
175
200
225
250
275
98100102104106108110112114116118120
Jul
STOCK VALUATION MODEL
Expected Earnings Per Sharefor CAC 40 (Euros)
Industrial Production(1995=100)
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)
Fair-Value(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
Source: Thomson Financial.
- Global: France (CAC 40) -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 21
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
STOCK VALUATION MODEL
Expected Earnings Per Sharefor TOPIX (yen)
Industrial Production(1995=100)
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
Source: Thomson Financial.
- Global: Japan (TOPIX) -
Page 22 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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**
S&P 500 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
Figure 27.Figure 27.
- Earnings: US vs G5 -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 23
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
S&P 500 Forward Earnings*
Industrial Production(1992=100)
* 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.
Figure 29.Figure 29.
- Earnings & Output: US -
Page 24 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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
S&P 500 Forward Earnings*
* 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
Figure 31.Figure 31.
- Earnings & Prices: US -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 25
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*
Industrial Production(1995=100)
* 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*
Industrial Production(1995=100)
* 12-month forward consensus expected earnings per share for FT 100.Source: Thomson Financial.
Yardeni
Figure 33.Figure 33.
- Earnings & Output: Europe -
Page 26 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
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*
Industrial Production(1995=100)
* 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
Figure 35.Figure 35.
- Earnings & Output: Japan -
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 27
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 -