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Global equity: Needs a new leader?

Oct 19, 2002

With a sharp rally in U.S markets over the past week, domestic bourses -- like global equities -- registered a positive week. However, spillover effect on global markets was restrained, which could indicate that investors do not have much faith in the U.S rally. That said, the domestic earning season is progressing well leading to improved sentiment.

Dow Jones: Power pack
Company CMP* ($) Mkt. cap ($bn) P/E**
Alcoa 23 19 37.9
GE 27 267 18.9
J&J 60 181 29.5
Microsoft 51 275 35.1
Amex 34 45 23.8
GM 35 20 14.1
JP Morgan 19 37 17.5
P&G 90 117 27.0
Boeing 30 24 86.4
Home Depot 29 69 19.5
Coca Cola 46 114 36.1
SBC Com. 25 82 16.1
Citigroup 36 182 11.4
Honeywell 22 18 28.3
McDonalds 18 23 14.5
AT&T 12 46 -
Caterpillar 40 14 21.3
HP 13 39 -
3M 125 49 28.8
United Tech 60 28 14.2
DuPont 42 42 19.6
IBM 72 123 23.8
Philip Morris 40 86 9.1
Walmart 55 246 33.4
Disney 17 34 30.7
Intel 14 95 47.7
Merck 51 115 16.0
ExxonMobil 36 246 23.2
Kodak 32 9 44.4
Int. Paper 37 18 -
*Current market price on 17/10/02,
** trailing 12-months

Over the past week, Dow Jones and Nasdaq jumped by 14.2% and 15.5% respectively. However, in all probability, U.S markets are likely to register three consecutive years of negative return. Year-to-date, Dow and Nasdaq are down 17.4% and 34.9% respectively (Sensex - down 7.9%). Having fallen consistently for more than a month, the bounce back is likely to have received further support from blue chips meeting earnings guidance. Divergent schools of thought on future direction of the economy is likely to be resulting in increased volatility. Markets touching 5-year lows and corporates meeting guidance have come as shot in the arm for the bulls. On the other hand, citing valuations, bears believe in further downside. Post September 11, rally in the U.S markets was supported by expectations of sustained economic recovery from second half of 2002. Stretched valuations were justified, as earnings were expected to bounce back. We had maintained that with earnings bouncing back, valuations will revert to mean, weighing down on any market uptrend. At 8,275 the Dow Jones trades on a rich multiple of 26.9x trailing 12-month earnings. However, more weight is given to forward earnings multiple, as markets discount future performance. On 1-year forward earning estimates (Yahoo Finance), at current levels, the Dow is trading on a multiple of 21.2x.

Assuming a long-term average 1-year forward earnings multiple of 20x, Dow is trading near to mean. On a multiple of 21.2x, the implied future earnings growth rate is 27.2% -- as earnings increase price/earning ratio (PER) declines. Over the past two years, despite bursting of the bubble (return to rational expectations) and a weakening economy (reflected by reducing interest rates), U.S investment community continued to expect earnings growth. Consequently, corporates have not been able to match expectations leading to bigger disappointment on the street reflected by sharper correction on markets. Hubris on part of the community to accept weakening fundamentals is likely to have accentuated the pain.

That said, for Dow to sustain current levels, the economy will have to recover over the next 12-months and earnings growth will have to pan out as per expectations. Intuitively itself, and considering recent earning disappointments, the risk to Dow performance is on the downside. At current multiples, lower than implied growth over next 12 months will weigh down on the index.

Dow: Where is it headed?
Dow Jones (17/10/02) 8,275
Trailing 12-month P/E 26.9
1-year forward P/E 21.2
Implied earnings growth* 27.2%
* Yahoo Finance

Further, a long-term average 1-year forward earnings multiple of 20x implies that in bullish times, due to higher expectations, valuations -- PERs -- are likely to get stretched (25x). While in bear phases - due to all-round pessimism resulting in lack of hope -- PERs tend to contract (15x). At 21x 1-year forward earnings, the multiple implies that the economy/earnings have bottomed out. In recent past, markets have adjusted to earning declines only post event -- not been able to call a bottom. Consequently, there is a risk of the same being repeated.

Bear phases, characterised by declining markets, are as much about contraction in expectations -- lack of confidence in future prospects. Although markets have declined, implied future earnings growth of 27% suggests that the second maxim is not being met. And so we hear markets waiting for 'final capitulation'. However, belief in future prospects continues to stubbornly linger, which could lead to a more drawn out bear phase. That said, at 15x 1-year forward earnings, the Dow Jones value works out to 6,034. An Equitymaster poll suggests that 83% of users believe U.S sentiment towards equity will affect domestic market performance. Consequently, impetus from the West looks unlikely.

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