Market / Economic Update

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.