The positive spins again OR show me where there is trouble and we can both make money! : LUSENET : TimeBomb 2000 (Y2000) : One Thread

For educational purposes only From the 8/6 issue of merrill lynch at first quick read, there seem to be no problems, only slight lessening of earnings if positioned badly.

no names to protect the innocent

United States

Payroll employment rose by 310,000 for July, far more than expected. That's probably too strong for the Federal Reserve's taste. Our Fed reaction function is a proprietary model that we use to forecast short-term changes in Fed policy. The July jobs data and their effect on the bond market caused the reaction function to generate a tightening signal. We expect a 25-basis-point increase, with the Federal funds target rising to 5.25 %. To avoid further tightening after August 24, job growth must slow. We assume that it will, but time will tell. The bond market has already priced-in a Fed tightening. We expect the market to remain unsettled in the near term, but yields should eventually move lower. Right now, worries about the Fed and inflation are being partly offset by a subtle quality bid that has developed in recent days as swap spreads have widened sharply. However, domestic demand is beginning to moderate and, with both short-term and long-term rates moving higher, will almost certainly moderate further. Consequently, we think that bond yields will fall below 6% by year-end. During the first half of 1999, GDP grew at a 3.3% rate, fairly close to the Fed's notion of growth potential and the slowest pace in nearly three years. We expect the economy to grow at roughly the same pace during the second half, although third-quarter growth may run at a rate of about 3.5%. However, the niix of growth will probably change in ways that the Fed should approve: less domestic demand growth, less trade deterioration, and more inventory building. We expect core inflation to remain dormant, even though some further energy pressures are in the pipeline. Productivity temporarily faltered in the second quarter, rising at a 1.3% rate. Even so, productivity was still up by 2.9% year-to-year; we think that it is likely to pick up during the second half Unit labor costs, the raw ingredient of inflation, rose at a discomforting 3.8% rate in the second quarter because productivity gains were weak. Nonetheless, unit labor costs were up by only 1.4% year-to-year, and we expect them to remain around that pace for 1999. In view of the strength of second-quarter earnings, we are raising our top-down earnings estimates for 1999. We now expect S&P 500 operating earnings per share to rise by 12% to $49.50, led by the technology sector. Our previous estimate was $49.00. Prospects for 2000 depend very much on the Fed. We currently project GDP growth of 3% for next year and expect S&P 500 operating EPS to rise by 7 % to $53.00. If the Fed tightens again after the August 24 rate hike that we expect, earnings and growth prospects for 2000 will probably need to be downgraded. Bruce Steinberg Chief Economist


Our base-case for Japan is that the economy will stage a slow recovery in 1999-2000 highlighted by further improvement in the supply/demand imbalance. That is likely to occur against the background of a strong recovery in emerging econoniies in Asia. The Japanese cyclical upswing received a boost from the latest report on industrial activity, which showed that inventories are falling and shipments are rising. Improving supply/demand conditions pushed industrial production for June up by a sharp 3% on a month-to-month basis. That was the first monthly increase in three months and the largest monthly gain in 29 months. Continued improvement in the inventory/shipment ratio suggests that the annual rate of change in production will turn positive during the current quarter. There have also been signs of improvement on the consumer side of the economy. Car sales in Japan have rebounded sharply during the past 14 months, for example. Sales of autos are currently increasing at a year-to-year rate of 4%; in March 1998, they were declining at a 20.8% clip. The improvement in car sales, the growing wealth effect from the advance in the equity market, and rising real wages suggest that Japan's personal consumption data could surprise investors on the upside in 1999-2000. Improving domestic demand is positive for the cyclical recovery, but the yen's recent strength isn't. That's because it poses a threat to the upturn in Japan's exports. The yen is about 22% above the eight-year low of YAJS$ 147.3 that it reached on August 11, 1998. The currency has also gained about 7% against the euro during 1999. That strength has forced the Bank of Japan to sell yen several times in the past two months, but the interventions have met with little success. & A key element in the yen's strength has been the sharp reduction in the outflow of money from Japan in the past several months. Outflows have slowed from a peak of V2.6 trillion in June 1998 to YO.2 trillion in May 1999. In addition, foreign demand for yen has picked up, aided by the upsurge in the Japanese stock market. On balance, we expect a cyclical upturn of about 1 % in Japan's GDP in both 1999 and 2000. That is above the latest (July) consensus estimates of +0.1 % for 1999 and -0.2% for 2000. On a longer-term basis, the Japanese economy will have to rely less on fiscal stimulus and more on private demand before a secular recovery begins to unfold. With another stimulus package of about Y5 trillion expected later in the year, the already-huge fiscal deficit (6% of GDP in 1998) could widen further. That, unfortunately, is not a good foundation for solid long-term growth. Global Research Highlights - 6 August 1999

Global View

If the U.S. stock market corrects, what will happen to non-U.S. markets? We think that they will find their own sources of liquidity. In our view, global investors should emphasize developed markets outside the U.S., particularly Japan. We also continue to favor Europe. Investment activity has been the fuel for the U.S. economy in recent years. If it slows from its blistering pace, the economic news from other areas of the world could look better than the news from America. Indeed, the "rest of the world" seems to be recovering, while recent U.S. economic data have been on the soft side. There are signs that flows of liquidity in the U.S. market may be flagging a bit. One is the dollar's recent weakness, which may indicate that the huge U.S. current-account deficit is becoming increasingly difficult to sustain. Another is the increase in quality spreads between corporate bonds and Treasury issues. In our judgment, that is a sign that the financial sector is finding it increasingly expensive to boff ow money, and the quality of that sector's balance sheet is coming into question. * Conditions are different elsewhere in the world. One sign of the times is that European companies have been on a buying spree in Japan lately; despite the country's current problems, many market participants think that Japanese stock prices are low in relation to the opportunities that exist in the economy. In addition, Japanese companies are beginning to look to their domestic markets to build a strong business base that will enable them to cut costs. Another point to consider is that the introduction of defined-contribution pension plans in Japan is forcing companies to pay more attention to the returns that those plans generate. In our judgment, the emergence of a stockholder culture in Japan could dramatically change the mind-set of corporate managers who traditionally have put market-share considerations above shareholder returns. We also think that Asian economics, including Japan's, are more insulated from the effects of tigther money than the U.S. economy because they are generating their own liquidity. That does not mean that they will be immune from any sell-off that might occur in the U.S. financial markets, but it does suggest that their recoveries could be more rapid. As we see it, cyclical upturns in Asian markets are likely to stay on course even if the U.S. markets correct.

Emerging Markets

o Volatility has increased in the Asian markets in recent weeks. We think that global investors ought to keep an eye on Hong Kong for clues to the course that the emerging markets might follow in the months ahead. If near-term risks dissipate and real interest rates recede, Hong Kong is unlikely to be an impediment; if problems persist, Hong Kong could act as a restraint. o Hong Kong and the emerging markets have been closely linked in recent years. In 27 of the past 30 months, the MSCI Hong Kong Index and the MSCI Emerging Markets hidex have moved in the same direction. The Hong Kong and Japanese markets have also tended to move more-or-I @ess in tandem lately. That's not surprising: for many investors, investing in Asia means investing in Japan and Hong Kong, which have by-far the largest total capitalizations in the region.

o Three main factors appear to be behind the increase in volatility in Asia. They are jitters about the possibility that China will devalue its currency, concern about the direction of U.S. interest rates, and the recent swings in the dollar/yen exchange rate. Those factors are short-term negatives in the outlook for Hong Kong and, by extension, the emerging markets, but we suspect that each of them is likely to be overdone by investors in the near term.

o Many market participants expect China to devalue the renminbi in a matter of months (see page 5). As we see it, a devaluation might be a positive for the markets if it increases investors' confidence in the Chinese government's efforts to reflate the economy.

9 Meanwhile, the outlook for U.S. interest rates is intertwined with the outlook for the dollar/yen rate. If U.S. rates were to move modestly higher, we think that the yen could weaken vs. the dollar, giving a boost to Japan's reflation program. A stronger Japanese economy, in turn, would be a net positive for most of Asia that would probably offset the negative effects of an increase in U.S. interest rates. At the same time, we expect the yen to weaken in the medium term. One important element in that view is the 400-basis-point differential in favor of the U.S. between Japanese and American bond yields.

o Looking at Hong Kong in particular, many investors are concerned about the level of real interest rates, which is the highest it has been since the dollar peg was put into place in 1984. Domestic liquidity seems to be on the upswing in Hong Kong, but we don't think that a new bull market in equities is likely to begin in the near term. Global Research Highlights - 6 August 1999

United States

e The stock market appears to have entered a new phase of decline that could ultimately result in the major averages dropping by 10-to-15% or more from their recent peaks. Short-term momentum indicators recently reached moderately oversold readings, reflecting improvement that medium-term measures have lacked. In addition, we think that investor sentiment has remained overly complacent about market weakness. Although the bond market has continued to weaken, we believe that it is still in a bottoming process that should lead to an interim recovery in coming months.

9 Both the DJIA and S&P 500 recently broke their post- October uptrends. That raises the question of whether the market's recent weakness is at or near an end, or whether it is merely an early stage of a substantially larger decline that could persist into the late-summer or fall. Based on technical patterns and probabilities, we suspect that the latter alternative will prove to be the correct one.

* In that environment, we think that the extended large-cap growth, technology, and financial stocks, many of which have had deteriorating relative performances in recent months, have the greatest downside risk. Conversely, the re- latively unexploited and still-depressed small-cap and value stocks, which could have periods of downside volatility in coming weeks or months, will probably hold up better on a total-performance basis than their more-exploited counter- parts. In fact, that was recently the case, and if that pattern persists during further phases of market weakness, it would strongly suggest that the small-cap and value sectors will be the primary areas of leadership in the next market advance.

In the past, moderate oversold positions of short-term momentum indicators have often led to a rally or a resumption of a temporarily interrupted bull market. There have been occasions, however, when the market continued to decline until a deep oversold reading was reached (late- August 1998, for example). This time around, the market's failure to rally recently when a short-term oversold condition was first reached may indicate that last summer's pattern is developing again. Even if a rally were to occur in response to the short-term oversold reading, it probably wouldn't be a strong one or last long because medium-term momentum measures are not yet oversold, and sentiment still shows little evidence of improvement.

Although bonds may further test or possibly undercut their late-June lows, they are in an interim bottoming process, in our judgment, and will likely have a further recovery.

9 Groups showing strong or improving technical patterns include telecom services, oil services/drillers, oil and gas producers, biotechnology, advertising, and selected semiconductor and telecom-equipment issues.

Latin America/Asia/commodities

o Most Latin American equity markets have been under greater-than-usual pressure in recent months, and matters could get worse before they get better. The dollar-based MSCI Latin America index is about 17% below its early-May level, when many markets in the region reached record highs. The major market averages in the U.S. have declined by about 3% during that time. That means that the setback in Latin America has been more than five-times greater than the dip in the U.S.; during the past decade, the average decline in Latin America has been only twice the average decline in the United States. Right now, medium-term momentum indicators for Latin America are negative, and technical indicators suggest that the U.S. market could come under some pressure in the period ahead. That may point to further weakness in Latin America before a good intermediate-term bottom is in place.

The MSCI Asia dollar index has declined by 9% since July 9. The index has broken below its early-1999 uptrend line, and the recent decline has been confirmed by medium-term momentum oscillators. That indicates that Asia is in the early stages of an intermediate-term decline; downward pressures could persist into the end of the year. Weather-related surges in prices for corn, wheat, and soybeans have been the main features of the commodity markets in recent days. Will those rallies last, and do they indicate that connnodities are headed for an imminent, across-the-board inflationary binge? The answer to the first question is that the grain and soy complex may have bottomed, but the bottom was at very low levels. We do not expect prices to rally to levels that exceed their historical norms. a The answer to the second question is no, in our view. We continue to think that prices are declining at a slower pace and that commodities now seem to be more of a neutral factor than a deflationary influence. As we see it, market participants who think that a meaningful round of commodity inflation has arrived are getting ahead of themselves. We continue to think that 1999 will be a transitional year during which the tenor of the markets will change from abject bearishness to a somewhat stronger tone. Next year there is likely to be a modest upturn in commodity prices, but not a serious inflationary push higher. Keep in mind that commodity prices are generally at very low levels: at about 196, the CRB index is only 14 points above the 24-year low it established this July and 68 points below the eight-year high it reached in April 1996.

.1., Fixed-income Focus

Currency Focus

United States China

o The bond market continues to be hobbled by expectations that the Federal Reserve will tighten and by concerns about the consequences of a weaker dollar. We believe that the market is over-reacting. We think that there is little threat that inflation will rise materially, especially if the Fed tightens further. In addition, the recent decline in the dollar has been relatively small. In fact, the greenback is up for the year vs. the euro and about unchanged vs. the yen.

o The Treasury recently announced that it is buying back some of its existing debt. 'Mat would enable the Treasury to keep the supply of current issues more plentiful by permitting auction sizes to be bigger than they would otherwise be. The Treasury also announced that it is eliminating the November auction of 30-year bonds and considering trimming back both the one- and two-year auctions. Those changes are all part of the large paydown in Federal debt that is occurring because of the Federal budget surpluses. One key result for investors is that the Treasury market may become less liquid. Another important consequence is already being realized: spreads between Treasurys and other debt have been widening.

e We consider spreads in the corporate, agency, and

imor preferred stock markets to be very attractive. In some areas, those spreads are approaching the extreme levels they reached during the global financial crisis last October. The wide yield premium on those securities vs. Treasurys reflects the shrinking Treasury supply, concerns about how a Fed tightening might affect corporate profits, and a desire for liquidity amid Y2K considerations. We believe that current spread levels more than adequately compensate investors for those risks.

9 We continue to think that the best opportunities for investors seeking high-quality issues are in the agency market. For investors who are comfortable moving down the investment-grade scale, we recommend the preferred-stock sector, which offers yields in the 8% and even 9% range. The areas that we think offer the best value in the preferred market are banks, financials, and REITS.

o Is the stage being set for what might be the world's most- widely anticipated currency devaluation? We think that the answer is yes. We believe that a currency devaluation may take place early in 2000 and that the Chinese renniinbi could weaken to 9-to 9.5 to the dollar. A managed, but more-flexible, float could emerge after that. o The Chinese government has been coming under increasing pressure to adjust its exchange-rate policy, after having honored its no-devaluation pledge for the past two years. Those pressures include economic weakness that permitted the forces of deflation to persist and deepen during the first half of 1999 and a deteriorating balance-of-payments position.

* The alarm that devaluation talk used to cause was based on the concern that China was the next Asian economic meltdown waiting to happen and that such a meltdown would be signaled by a currency devaluation. We disagree with that view. A move by China to a more-flexible exchange-rate policy would be a positive development, in our view. Moreover, we think that many other market participants now share that perception.

o A shift in exchange-rate policy would strengthen the Chinese government's reflation efforts and should be positive for China's growth and reform prospects. Hong Kong should benefit as well after any initial shocks wear off. The winners in the financial marketplace are likely to be companies in export- related industries and manufacturers of import-substitute goods with high local-content levels; the losers are likely to be companies with high levels of foreign-currency debt.

o A strong and rigid currency is perhaps the last thing China needs. Such an exchange-rate regime would be increasingly inconsistent with the government's monetary reflation efforts. A policy mix of fiscal stimulus, stronger monetary reflation, and exchange-rate adjustments would be a more-potent weapon in China's fight against deflation.

o As we see it, a more-favorable external environment of economic recoveries in Japan and Asia should encourage China to make the exchange-rate policy shift. In light of the sizable external surpluses many Asian economies are running and the undervalued position of many Asian currencies, we do not believe that a devaluation of the renniinbi would destabilize other Asian currencies.

9 For a complete discussion of our view that a devaluation lies ahead, please see our August 3 China Economics report.

Quantitative Overview

United States

* We remain strongly in favor of value, small-cap, and lower-quality stocks. Elements in our view include the fact that lower-quality stocks continue to outperform higher-quality ones by a wide margin. In addition, our growth and value indicator points toward value, our Sell Side indicator has edged up, and our valuation models have deteriorated further. 9 In our view, the S&P 500 will provide a single-digit total return during the next 12 months; that doesn't compare well with the long bond's current yield of about 6 %. We suggest that investors continue to take a cautious approach to the stock market and emphasize the "not-so- nifty 450." o Lower-quafity stocks have been outperforming higher- quality ones lately by a very wide margin (see chart below). Our index of stocks with C and D quality ratings from Standard & Poor's rose by 1. I% last month and outperformed our index of A+ stocks by 385 basis points. On a year-to-date basis, the C&D index has advanced by 38.8%, and the A+ index is ahead by 2.2%, a difference of 36.6 percentage points.

9 Our growth and value indicators now show eight in favor of value and two in favor of growth; the tally last month was nine and one, respectively. Our Alpha Surprise model switched to the growth column by overweighting higher- quality stocks. We don't think that the change is a significant one, particularly because other indicators are moving more- strongly into the growth camp. For example, the slope of the yield curve has actually been getting steeper since the Federal Reserve tightened.

o The Sell Side indicator has been our most-reliable quantitative market-timing barometer. It is a proprietary sentiment model based on Wall Street's consensus recommended asset allocation. We have found that the consensus recommended asset allocation is a reliable contrary market-timing indicator. In other words, it has historically been bullish when Wall Street was overly bearish, and vice versa.

o The latest reading of the indicator (July 31) is 56.7%, up from 56.3% last month. The new reading indicates that the typical investment strategist is suggesting that 56.7% of a balanced fund be in equities. The indicator is getting close to giving another formal sell signal; such signals are generated by readings of 57. 1 % or higher (buy signals are generated by readings of 50.3% or lower). The indicator is now less than 50 basis points from giving a formal sell signal.

o The last time the indicator moved that close to giving a formal sell signal was June 1998. Although the indicator did not give a formal sell signal at that point, the fact that it was so close to giving one was one of the factors that led us to our initial underweighting of equities (we had consistently overweighted equities from January 1995 until mid-1998).

* The indicator's near-sell position in June 1998 seemed to be a good signal because the market corrected during the next several months. Unfortunately, the actual sell signal from the model came late, and the market advanced after the signal. 9 More important, the majority of our valuation models signaled that the market was overvalued during June 1998, and they all suggest that that is the case today. Even our notoriously bullish Dividend Discount Model (the only model in our arsenal to suggest that last October was a unique buying opportunity) now suggests that the S&P 500 is overvalued by about IO%.

o Valuation disparities between large-cap and smaller-cap issues continue to skew our models. As a result, we have a cautious view of the prospects for the overall S&P 500, but we remain very strongly in favor of the "not-so-nifty 450" (NSN450). ff we are correct in our view that long-term interest rates are still likely to rise, the nifty-50-doniinated S&P 500 might perform relatively poorly, while the NSN450 could do quite well. The earnings of the NSN450 tend to be positively correlated with the economic factors that might push up long- term rates; the earnings of the nifty-50 generally aren't.

-- Same as B4 (, August 17, 1999


P.S. our industry is on fire and Kosky's SUV is parked in front of the hydrant

-- Safer (, August 17, 1999.

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