Message-ID: <2963539.1075840409611.JavaMail.evans@thyme> Date: Fri, 1 Feb 2002 13:27:30 -0800 (PST) From: rod.kennedy@rbc.com To: kennedy@enron.com, rod.kennedy@rbc.com Subject: Market / Economic Update Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: quoted-printable X-From: "Kennedy, Rod" @ENRON X-To: Kennedy, Rod X-cc: X-bcc: X-Folder: \ExMerge - Dorland, Chris\Inbox X-Origin: DORLAND-C X-FileName: chris dorland 6-26-02.PST Some points of interest for the week,=20 Equity Market Update=20 There is a tug-o-war in the market between the crisis in confidence caused = by the Enron debacle and the increasingly positive nature of the economic d= ata. First, let's chat about the Enron fall-out. The market seems to be suffering from a nasty case of Enron-itis, as some o= f the talking heads have called the recent negative sentiment in the market= . Clearly something changed with the bankruptcy of Enron. It is the largest= US bankruptcy ever. There are not one, but two official governmental inves= tigations of the company and further investigations are likely. The bankers= , accountants and the lawyers are also going to get a hard look. What has t= he market particularly bothered is the glaring oversight by Arthur Anderson= (AA), one of the big five accounting firms. Delta Airlines has been using = AA for over 50 years and they are looking for a new auditor. Also, the cred= it rating agencies dropped the ball too. One of them actually upgraded Enro= n's debt a few weeks before its demise. What is the investing public to thi= nk? Who can you trust? Generally, investors understand that the Street's ad= vice needs to be viewed with a critical eye, but the accountants were suppo= sed to be looking out for investors. It certainly makes you say hmmmmm... The market hates uncertainty and the level of uncertainty has increased gre= atly and it is not likely to dissipate for some time. Imagine the discussio= ns at the other accounting firms. Companies are not going to be able to sli= p anything by their accountants from now on. Standards are going to be toug= hened up and that may cause some pain for companies that have pushed the en= velope in the past. In addition, the market is going to search and destroy = every company that has Enron-like qualities. Off-balance sheet partnerships= or structures, complicated financial statements and foreign domiciled tax = structures. It started almost right away with the decimation of Enron's com= petitors, Williams (WMB), El Paso (EP), Mirant (MIR) and Calpine (CPN), who= have had to sell assets and issue stock in order to repair their balance s= heets. Some of those companies are trading as if we will never need power o= r natural gas again (EP is my favourite among these companies, as you know)= . Next, the market had its day or so with the asbestos-infected companies a= nd then more recently proceeded to anyone with off-balance sheet assets or = a history of accounting indiscretions. We had better get used to this sort = of roller-coaster existence. With over 6,000 hedge funds, a hyper-active me= dia and market information available 24/7, the witch hunts will continue. S= till, it is important to note a few things:=20 First, not all companies with off-balance sheet items are guilty of transgr= essions and not every company that acquires others for a living (a la Tyco)= violates standard accounting principles. In fact, nobody has proven (yet) = that Tyco has done anything improper. The risk of impropriety makes people = sell, not the fact. Second, regardless of whether your company is guilty of doing anything nast= y, if it plays in the same sand-box as a company that attracts the ire of i= nvestors, it is going down. Period. Full stop. No matter if it is guilty of= anything or not. These are market events not business events. Consider the= pain and suffering experienced by El Paso (EP) thanks to Enron or Viacom (= VIA.b) thanks to Haliburton (HAL) and its asbestos exposure. Viacom bought = CBS which owned Westinghouse once upon a time, but that did not stop the st= ock from getting pasted even though it is insured and reserved up the wazoo= ('up the wazoo' is a technical term signifying a significant amount). Third, emotions and sentiment can push stock prices around a great deal in = the short term, but over the long term, stock prices are determined by a co= mpany's ability to generate cash. The best opportunities are likely to come= from buying companies with low debt levels that are relatively free of con= troversy, but have been beaten up because they resemble another company wit= h a real problem. Biovail (BVF), Viacom (VIA.b), El Paso (EP), etc. However= , each of these names also comes with an increased risk profile as a result= of the market's heightened sensitivity to 'issues' (accounting, asbestos, = debt levels, litigation, etc.).=20 On the economic front, the data seems to be point to an economic recovery t= hat is already underway.=20 Consumer confidence rose from 94.6 to 97.3 in January and was up for the se= cond straight month. The index is now above the pre-September 11 level. Als= o the expectations component of the index was the highest in over a year, s= uggesting that consumer spending should continue to hold up well.=20 Durable Goods orders rose in December and importantly the ex-transportation= orders rose for a third month in a row, the longest streak of gains in 4 y= ears.=20 New home sales rose stronger than expected and taken together with last wee= k's existing home sales, total home sales were above 6.1 million (annualize= d) and stable.=20 Today, the unemployment rate fell to 5.6% and the 4-week moving average of = jobless claims fell to its lowest level since August; and the ISM (NAPM) in= dex came in at 49.9 vs. 50.0 expected and new orders remained above 50, ind= icating order volume is expanding.=20 Finally, on the international front, the German Business Confidence index r= ose and is now close to its pre-September 11 level.=20 Unfortunately, Japan continues to struggle. The Japanese unemployment rate = rose to a record high 5.6% and real wage-earning household spending fell 4.= 4% compared to last year. Both figures were worse than expected and the dro= p in household spending does not bode well the prospects of an economic rec= overy. Also, the yen continues to slide as confidence in the government and= the economy wanes. The Japanese fiscal year ends on March 31st and there i= s widespread concern that the country's banks will have to mark down the va= lue of more loans and investments, potentially pushing some of them into ba= nkruptcy. Of course, a number of bankruptcies would be a good thing much li= ke the S&L crisis was for the US in the early 1990s. A cathartic cleansing = followed by an audible flush could lead to a great buying opportunity. Stay= tuned. Financials - The US banks are trading very poorly - no wonder. Credit quali= ty, which everybody knew was bad, has turned out to be at least as nasty as= expected or worse. PNC Financial (PNC) had to restate its earnings when th= e SEC forced the company to consolidate 3 subsidiaries, K-Mart (KM) filed f= or chapter 11, Global Crossings (GX) shuts its doors, and today, the 2nd bi= ggest European cable company defaulted on $6.4 billion in debt and preferre= d stock. When you add these events on to the Enron scenario, it makes inves= tors of all kinds hold a bit more cash, a few more government bonds and a l= ittle less equity. This is the kind of pain that is quite typical for the t= rough of the credit cycle. As you know, JP Morgan (JPM) has been a recommen= ded stock for many quarters, however it looks like it will be removed from = the US Focus List as it has broken our technical screen. The stock remains = buy or strong buy rated around the Street and a great deal of bad news woul= d seem to be already priced into the stock. However, the risk of further ne= gative credit events seems quite high, and as a result, we suggest that new= money go into Citigroup (C), which is trading at just under 14x 2002 EPS v= s. its historical range of about 12x to 20x. Out anlayst's comments on Sun = Life (SLC) suggest this is a name we should continue to accumulate. Sun Microsystems (SUNW) is under pressure following negative comments by Me= rrill. According to Merrill, recent comments by ORCL's Larry Ellison give c= ause for concern about SUNW's high-margin Unix server mkt; ORCL is replacin= g 3 Unix servers with a cluster of INTC servers running Linux; concern is t= hat SUNW's Unix biz will be attacked from below by INTC servers running NT = or Linux (particularly Linux, as it's easier to learn than SUNW's Solaris o= perating system). Microsoft (MSFT) was added to Goldman Sachs portfolio and= Oracle (ORCL) was removed.=20 Calpine (CPN) was downgraded to Deutche Bank to BUY from Strong Buy due to = a lack of near-term catalysts in the stock; current risks include: continue= d weakness in power prices and spark spreads, the California DWR contract r= enegotiations, a highly leveraged balance sheet, and a tight cash flow situ= ation. Price target is $20. We should get used to reading recommendations l= ike this one. The list of risks is large and imposing and yet many of you w= ill notice that the target is $20 suggesting a 72% return is possible over = the next 12 months. We would encourage investors to focus on the risks and = the likelihood of them happening rather than a highly subjective target. In Canada, focus on Focus List names Sun Life (SLC) and Shaw Communications= (SJR.b). Suitability is everything, never more so than in the current mark= et environment. Interest Rate Update=20 The big, but not so surprising news yesterday was the decision by the FOMC = to keep the Fed funds rate steady at 1.75%, while the discount rate remaine= d at 1.25%. also as expected, the Fed maintained their easing bias. This = was the first "no change" following an FOMC meeting since Dec/00, after 4.7= 5% of cuts in 11 steps through 2001. The committee noted that there are "= signs that weakness in demand is abating and economic activity is beginning= to firm have become more prevalent". This is different from the last comm= ent on Dec 11 when they stated "weakness in demand shows signs of abating, = but those signs are preliminary and tentative". The easing bias was justif= ied due to the uncertainty of the strength in business capital and consumer= spending. RBC CM Economics believe that this statement will be a sign of = things to come, with rates in a holding pattern, and an easing bias remaini= ng, until the recovery is firmly and sustainably in place. They are callin= g for the first hike to occur no earlier than September. - Fed funds future= s are pricing in earlier expectations - the July contract is indicating a 1= 00% chance of a 25 bps hike. Stocks are the bigger news with Nasdaq stock futures up 10.50 pts after an = upgrade to Intel by Merrill Lynch, gains in Oracle after the company reaffi= rmed its profit target, and Applied Materials stating that a bottom has com= e and gone for the industry.=20 Have a good weekend and be good,=20 Rod.