MPSIF Economic UpdateMPSIF Economic Update

April 5April 5thth, 2004, 2004Stern School of BusinessStern School of Business

New York UniversityNew York University

Market Trends: Quarter RecapMarket Trends: Quarter RecapBig markets flat; Small caps Big markets flat; Small caps

continue to outperformcontinue to outperform Dow Jones Industrial Average Dow Jones Industrial Average ↓↓ 0.91% 0.91%

S&P 500 ↑ 1.29%S&P 500 ↑ 1.29%

NASDAQ Composite ↓ 0.84% since Annual ReportNASDAQ Composite ↓ 0.84% since Annual Report

Russell 2000 Index ↑ 6.00%Russell 2000 Index ↑ 6.00%

1Q04 earnings expected to be up 17% yoy (above estimate)1Q04 earnings expected to be up 17% yoy (above estimate)

March 2004 dividend up 16.5% over March 2003March 2004 dividend up 16.5% over March 2003

10-year rates start at 4.15 fall to 3.70 late in March, then return to 4.17 last 10-year rates start at 4.15 fall to 3.70 late in March, then return to 4.17 last

Friday (rate went up .29% in one day!)Friday (rate went up .29% in one day!)

Economic Fundamentals – Economic Fundamentals – Trends and EstimatesTrends and Estimates

Fed Rate:Fed Rate: Jobs report increases probability of a Fed increase this summerJobs report increases probability of a Fed increase this summer Futures prices for July and August suggest a 38% and 70% probability Futures prices for July and August suggest a 38% and 70% probability

of a 25bp increase by those dates, respectively, up from 16% and 32% of a 25bp increase by those dates, respectively, up from 16% and 32% the day before the jobs reportthe day before the jobs report

But, these probabilities are down from February, when futures prices But, these probabilities are down from February, when futures prices were predicting 72% chance of a 25bp increase by July and a 100% were predicting 72% chance of a 25bp increase by July and a 100% chance of a 50bp increase by November chance of a 50bp increase by November

Triggers are inflation gap and GDP gap… and election?Triggers are inflation gap and GDP gap… and election? GDP: GDP:

4.1% increase in 4Q03.4.1% increase in 4Q03. Analysts continue to expect 4.5% for 2004.Analysts continue to expect 4.5% for 2004.

Inflation: Inflation: Reached a 40 year low of 1.1% in November, expected to rise to 2.0% Reached a 40 year low of 1.1% in November, expected to rise to 2.0%

November 2004November 2004 Import prices have risen 5 consecutive months, but still low. Import prices have risen 5 consecutive months, but still low. Capacity utilization remains low, but rising.Capacity utilization remains low, but rising.

Employment ReportEmployment Report

March Unemployment Rate 5.7%, March Unemployment Rate 5.7%, up from 5.6%up from 5.6%

Nonfarm payrolls increased 308,000Nonfarm payrolls increased 308,000 largest gain since April 2000largest gain since April 2000 11stst month in 44 mfg jobs did not month in 44 mfg jobs did not 230K of jump from services230K of jump from services

Signal that more formerly Signal that more formerly discouraged workers looking for discouraged workers looking for jobsjobs

Hourly earnings Hourly earnings measly .1% measly .1% Annual rate 1.8%Annual rate 1.8%

Average workweek 33.7 hours, Average workweek 33.7 hours, down a bit from 33.8down a bit from 33.8

Oil and Gas OutlookOil and Gas Outlook OPEC cut production quota by 1 mbbl/d in anticipation of seasonal OPEC cut production quota by 1 mbbl/d in anticipation of seasonal

demand reductiondemand reduction Until April 1Until April 1stst, OPEC production at 26 mbbl/day, OPEC production at 26 mbbl/day OPEC committed to reduce by 1.5 mbbl/d “cheating” ineffectiveOPEC committed to reduce by 1.5 mbbl/d “cheating” ineffective Decision to cut production contentious within OPEC; Saudis supportiveDecision to cut production contentious within OPEC; Saudis supportive OPEC under pressure from U.S. administrationOPEC under pressure from U.S. administration

Natural pas prices remain high (supply and demand imbalance)Natural pas prices remain high (supply and demand imbalance) Oil and gas one-month futures prices dropped Friday by 3-4%Oil and gas one-month futures prices dropped Friday by 3-4%

Caused by strengthened dollar and comments by Kuwaiti and Saudi oil Caused by strengthened dollar and comments by Kuwaiti and Saudi oil ministersministers

Conclusion: Oil tough to call; gas prices likely to remain strongConclusion: Oil tough to call; gas prices likely to remain strong

25

27

29

31

33

35

37

39

29-Sep 24-Oct 18-Nov 13-Dec 7-Jan 1-Feb 26-Feb 22-Mar

NY

ME

X W

TI C

us

hin

g C

rud

e (

bb

l/d) Crude Oil

U.S. Currency MarketsU.S. Currency Markets Friday’s payroll announcement strengthened dollar relative to euroFriday’s payroll announcement strengthened dollar relative to euro

ECB continues to focus on inflationary pressures, maintaining higher ECB continues to focus on inflationary pressures, maintaining higher interest ratesinterest rates

Dollar has strengthened against the yen in last three weeksDollar has strengthened against the yen in last three weeks Japan had purchased Japan had purchased 22//33 (~¥3.5 t) of its 2003 total through March (~¥3.5 t) of its 2003 total through March Indications that intervention slowed dramatically in late-MarchIndications that intervention slowed dramatically in late-March

Japanese and Chinese intervention in currency markets has helped finance Japanese and Chinese intervention in currency markets has helped finance U.S.’s current account and budget deficitsU.S.’s current account and budget deficits

Conclusion:Conclusion: Increasing growth and subsequent increase in interest rates will Increasing growth and subsequent increase in interest rates will lesson support for exporters in near-term; influence unlikely to be felt until lesson support for exporters in near-term; influence unlikely to be felt until 20052005

1.12

1.14

1.16

1.18

1.20

1.22

1.24

1.26

1.28

1.30

26-Sep 15-Nov 4-Jan 23-Feb 13-Apr

$/E

uro

103

104

105

106

107

108

109

110

111

112

113

Yen

/$

Fixed Income OutlookFixed Income Outlook Approx. 28% of fund assets are in Approx. 28% of fund assets are in

bond fundsbond funds Fund charter requires securities to Fund charter requires securities to

be investment gradebe investment grade ~~11//33 each in treasuries, each in treasuries,

mortgages, and corporate bondsmortgages, and corporate bonds Most spreads over treasuries are Most spreads over treasuries are

below historical levelbelow historical level While interest rates stay low, While interest rates stay low,

continue receiving couponscontinue receiving coupons However, as rates increase over next However, as rates increase over next

year, capital losses likelyyear, capital losses likely

RecommendationRecommendation1.1. Reduce fixed income holdings (if Reduce fixed income holdings (if

possible)possible)2.2. Rotate into inflation-protected Rotate into inflation-protected

bonds (e.g., TIPS)bonds (e.g., TIPS)

U.S. TIPS, 10-yr weekly

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

12/10/2002 3/20/2003 6/28/2003 10/6/2003 1/14/2004 4/23/2004

Yie

ld (

%)

Source: U.S. Federal Reserve

Fall Presidential ElectionsFall Presidential Elections Bush/Kerry futures on IEM at Bush/Kerry futures on IEM at

0.52/0.48 0.52/0.48 As is typical, business supporting As is typical, business supporting

Republican over DemocratRepublican over Democrat Proportion more lopsided toward Bush Proportion more lopsided toward Bush

than at the end of the Bush/Gore racethan at the end of the Bush/Gore race Kerry’s “Jobs First” plan focuses on:Kerry’s “Jobs First” plan focuses on:

Tax incentives for companies that Tax incentives for companies that create jobs domesticallycreate jobs domestically

Slowing the export of jobs abroadSlowing the export of jobs abroad Assisting manufacturing sectorAssisting manufacturing sector Intends to increase taxes on wealthyIntends to increase taxes on wealthy

Bush has not outlined any significant Bush has not outlined any significant deviations from current policiesdeviations from current policies

Has alluded to make U.S. market less Has alluded to make U.S. market less litigious (e.g., cap on malpractice litigious (e.g., cap on malpractice awards)awards)

More sensitive industries: legal, real More sensitive industries: legal, real estate, securities & investment, estate, securities & investment, medicalmedical

Conclusion:Conclusion: Bush likely more Bush likely more favorable for global businesses; Kerry favorable for global businesses; Kerry for U.S. manufacturingfor U.S. manufacturing

Bush Kerry Total Bush Kerry1 Lawyers/Law Firms $7.66 $3.92 $11.58 66% 34%2 Real Estate $7.49 $0.88 $8.36 90% 10%3 Securities & Investment $5.51 $1.17 $6.68 82% 18%4 Misc Business $4.77 $0.59 $5.37 89% 11%5 Misc Finance $3.58 $0.41 $3.99 90% 10%6 Health Professionals $3.58 $0.46 $4.04 89% 11%7 Insurance $2.22 $0.17 $2.39 93% 7%8 Commercial Banks $2.09 $0.26 $2.35 89% 11%9 Misc. Manu. & Dist'n $1.65 $0.16 $1.81 91% 9%10 Automotive $1.56 n/r $1.56 - -

Contributions Fraction

Overall Rank Contributor

Total Contributions

To Dems

To Repubs Contributions Tilt

1 Goldman Sachs $2,656,413 51% 49% On the fence4 Lehman Brothers $1,272,063 45% 55% On the fence5 Citigroup Inc $1,262,072 46% 54% On the fence9 Morgan Stanley $1,039,883 37% 63% Leans Republican

12 Merrill Lynch $1,016,789 20% 80% Strongly Republican20 UBS Americas $912,738 28% 71% Strongly Republican22 MBNA Corp $875,647 23% 77% Strongly Republican32 JP Morgan Chase & Co $778,281 50% 51% On the fence33 American Bankers Assn $768,918 39% 61% Leans Republican35 Credit Suisse First Boston $739,500 36% 64% Leans Republican39 Northrop Grumman $702,522 37% 63% Leans Republican44 Bear Stearns $656,083 39% 61% Leans Republican60 Wachovia Corp $565,960 33% 67% Strongly Republican61 Bank of America $559,440 45% 55% On the fence73 Mass Mutual Life $446,300 44% 56% On the fence74 AIG $438,663 38% 62% Leans Republican76 Bank One Corp $434,336 46% 54% On the fence77 Wells Fargo $429,116 41% 59% Leans Republican81 Metropolitan Life $414,711 57% 43% Leans Democratic96 Cigna Corp $362,294 17% 83% Strongly Republican97 HSBC USA $360,500 39% 61% Leans Republican

Averages: 39% 61%

Sector RecommendationsSector Recommendations

Overweight: Financials (large cap), Overweight: Financials (large cap), Energy, Industrials, Materials, IT, Energy, Industrials, Materials, IT, Consumer DiscretionaryConsumer Discretionary

Neutral: Health Care, Telecom, Neutral: Health Care, Telecom, Technology, Utilities Technology, Utilities

Underweight: Financials (small cap)Underweight: Financials (small cap)

Consumer Staples Consumer Staples

Revisiting the question: Are stocks Revisiting the question: Are stocks overvalued? An interesting take from overvalued? An interesting take from

a value perspectivea value perspective Robert Weigand and Robert Irons study suggests Robert Weigand and Robert Irons study suggests

that high P/E ratios are no longer mean reverting that high P/E ratios are no longer mean reverting or indicative of negative future returns. or indicative of negative future returns.

They also find that high P/E ratios (above 21) They also find that high P/E ratios (above 21) have been associated with the highest average of have been associated with the highest average of 10 year earnings growth, and a positive 10 year 10 year earnings growth, and a positive 10 year rate of returns, going back to 1881.rate of returns, going back to 1881.

It seems that interest rates, at least since 1960, It seems that interest rates, at least since 1960, are a better predictor of earnings and returns.are a better predictor of earnings and returns.

All of this suggests P/E ratios can deviate from All of this suggests P/E ratios can deviate from the historical mean for long periods of time, or the historical mean for long periods of time, or even permanently. even permanently.

While P/E ratios have deviated While P/E ratios have deviated significantly from their historical significantly from their historical

mean…mean…

Source: Weingand & Irons, The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion

……E/P ratios have become E/P ratios have become cointegrated with 10-year Yieldcointegrated with 10-year Yield

Source: Weingand & Irons, The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion

E/P ratios and 10-year yield – E/P ratios and 10-year yield – what it all means for investorswhat it all means for investors

The 10-year rate and E/P ratios are highly, The 10-year rate and E/P ratios are highly, and positively correlated, meaning that and positively correlated, meaning that P/E ratios are negatively correlated with P/E ratios are negatively correlated with the 10-year yieldthe 10-year yield

Investors should keep a close eye on Investors should keep a close eye on interest ratesinterest rates

A bearish view on bonds means a bullish A bearish view on bonds means a bullish view on equitiesview on equities

Historical P/E ratios, at least for the Historical P/E ratios, at least for the market, are irrelevant!market, are irrelevant!