Asset Valuation Allocation Models

R e s e a r c h July 30, 2002

Dr. Edward Yardeni (212) 778-2646 [email protected] Amalia F. Quintana (212) 778-3201 [email protected]

Asset Valuation & Allocation Models

- Introduction I. Fed’s Stock Valuation Model How can we judge whether stock prices are too high, too low, or just right? The purpose of this weekly report is to track a stock valuation model that attempts to answer this question. While the model is very simple, it has been quite accurate and can also be used as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after reading that the folks at the Federal Reserve have been using it. If it is good enough for them, it’s good enough for me. I dubbed it the Fed’s Stock Valuation Model (FSVM), though no one at the Fed ever officially endorsed it. On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board, famously worried out loud for the first time about “irrational exuberance” in the stock market. He didn’t actually say that stock prices were too high. Rather he asked the question: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions….”1 He did it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of the market’s exuberance. Apparently, they did so and it was made public, though buried, in the Fed’s Monetary Policy Report to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on July 22, 1997. 3 The Fed model was summed up in one paragraph and one chart on page 24 of the 25page document (see following table). The chart shows a strong correlation between the S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E) to the price index for the S&P 500 companies (P), using 12- month-ahead consensus earnings estimates compiled by Thomson Financial First Call.—and the 10-year Treasury bond yield (TBY). The average spread between the forward earnings yield and the Treasury yield (i.e., FEY-TBY) is 29 basis points since 1979. This near-zero average implies that the market is fairly valued when the two are identical: 1) FEY = TBY Of course, in the investment community, we tend to follow the price-to-earnings ratio more than the earnings yield. The ratio of the S&P 500 price index to expected earnings (P/E) is highly correlated with the reciprocal of the 10-year bond yield, and on average the two have been nearly identical. In other words, the “fair value” price for the S&P 500 (FVP) is equal to expected earnings divided by the bond yield in the Fed’s valuation model: 2) FVP = E/TBY 1

http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm “We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table.” http://www.federalreserve.gov/boarddocs/hh/1997/february/testimony.htm 3 http://www.federalreserve.gov/boarddocs/hh/1997/july/ReportSection2.htm 2

Page 2 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

Excerpt from Fed’s July 1997 Monetary Policy Report: The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming twelve months has risen further from levels that were already unusually high. Changes in this ratio have often been inversely related to changes in long-term Treasury yields, but this year’s stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown. One important factor behind the increase in stock prices this year appears to be a further rise in analysts’ reported expectations of earnings growth over the next three to five years. The average of these expectations has risen fairly steadily since early 1995 and currently stands at a level not seen since the steep recession of the early 1980s, when earnings were expected to bounce back from levels that were quite low.

The ratio of the actual S&P 500 price index to the fair value price shows the degree of overvaluation or undervaluation. History shows that markets can stay overvalued and become even more overvalued for a while. But eventually, overvaluation is corrected in three ways: 1) falling interest rates, 2) higher earnings expectations, and of course, 3) falling stock prices—the old fashioned way to decrease values. Undervaluation can be corrected by rising yields, lower earnings expectations, or higher stock prices. The Fed’s Stock Valuation Model worked quite well in the past. It identified when stock prices were excessively overvalued or undervalued, and likely to fall or rise: 1) The market was extremely undervalued from 1979 through 1982, setting the stage for a powerful rally that lasted through the summer of 1987. 2) Stock prices crashed after the market rose to a record 34% overvaluation peak during September 1987. 3) Then the market was undervalued in the late 1980s, and stock prices rose. 4) In the early 1990s, it was moderately overvalued and stock values advanced at a lackluster pace. 5) Stock prices were mostly undervalued during the mid-1990s, and a great bull market started in late 1994. 6) Ironically, the market was actually fairly valued during December 1996 when the Fed Chairman worried out loud about irrational exuberance.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 3

7) During both the summers of 1997 and 1998, overvaluation conditions were corrected by a sharp drop in prices. 8) Then a two- month undervaluation condition during September and October 1998 was quickly reversed as stock prices soared to a remarkable record 70% overvaluation reading during January 2000. This bubble was led by the Nasdaq and technology stocks, which crashed over the rest of the year, bringing the market closer to fair value II. New Improved Model The FSVM is missing a variable reflecting that the forward earnings yield is riskier than the government bond yield. How should we measure risk in the model? An obvious choice is to use the spread between corporate bond yields and Treasury bond yields. This spread measures the market’s assessment of the risk that some corporations might be forced to default on their bonds. Of course, such events are very unusual, especially for companies included in the S&P 500. However, the spread is only likely to widen during periods of economic distress, when bond investors tend to worry that profits won’t be sufficient to meet the debt-servicing obligations of some companies. Most companies won’t have this problem, but their earnings would most likely be depressed during such periods. The FSVM is also missing a variable for long-term earnings growth. My New Improved Model includes these variables as follows: 3) FEY = CBY – b · · LTEG where CBY is Moody’s A-rated corporate bond yield. LTEG is long-term expected earnings growth, which is measured using consensus five- year earnings growth projections. I/B/E/S International compiles these monthly. The “b” coefficient is the weight that the market gives to long-term earnings projections. It can be derived as [FEY-CBY]/LTEG. Since the start of the data in 1985, this “earnings growth coefficient” averaged 0.1. Equation 3 can be rearranged to produce the following: 4) FVP = E ¸ ¸ [CBY – b · · LTEG] FVP is the fair value price of the S&P 500 index. Exhibit 10 shows three fair value price series using the actual data for E, CBY, and LTEG with b = 0.1, b = 0.2, and b = 0.25. The market was fairly valued during 1999 and the first half of 2000 based on the consensus forecast that earnings could grow more than 16% per year over the next five years and that this variable should be weighted by 0.25, or two and a half times more than the average historical weight. III. Back To Basics With the benefit of hindsight, it seems that these assumptions were too optimistic. But, Page 4 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

this is exactly the added value of the New Improved FSVM. It can be used to make explicit the implicit assumptions in the stock market about the weight given to long-term earnings growth. The simple version has worked so well historically because the longterm growth component has been offset on average by the risk variable in the corporate bond market. IV. Stocks Versus Bonds The FSVM is a very simple stock valuation model. It should be used along with other stock valuation tools, including the New Improved version of the model. Of course, there are numerous other more sophisticated and complex models. The Fed model is not a market-timing tool. As noted above, an overvalued (undervalued) market can become even more overvalued (undervalued). However, the Fed model does have a good track record of showing whether stocks are cheap or expensive. Investors are likely to earn below (above) average returns over the next 12-24 months when the market is overvalued (undervalued). The next logical step is to convert the FSVM into a simple asset allocation model (Exhibit 1). I’ve done so by subjectively associating the “right” stock/bond asset mixes with the degree of over/under valuation as shown in the table below. For example, whenever stocks are 10% to 20% overvalued, I would recommend that a moderately aggressive investor should have a mix of 60% in stocks and 40% in bonds in their portfolio. Bonds/Stocks Asset Allocation Model More than 30% overvalued 20% to 30% overvalued 10% to 20% overvalued 10% undervalued to 10% overvalued 10% to 15% undervalued More than 15% undervalued

70% bonds, 30% stocks 50% bonds, 50% stocks 40% bonds, 60% stocks 30% bonds, 70% stocks 20% bonds, 80% stocks 10% bonds, 90% stocks

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 5

70 60

80

ED YARDENI’S ASSET ALLOCATION MODEL: BONDS/STOCKS* (for Moderately Aggressive Investor)

70

Stocks overvalued when greater than zero Stocks undervalued when less than zero

60

50

50

40

40

70/30 30

30

50/50 20

20

40/60 10

10

30/70 0

30/70

-10

20/80 10/90

-20 -30 -40

7/26

0 -10 -20 -30

Yardeni

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-40

* Ratio of S&P 500 index to its fair value (12-month forward consensus expected operating earnings per share divided by the ten-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after. Source: Thomson Financial.

- Asset Allocation -

Page 6 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

80

- Valuation Model 1725 1575 1425 1275 1125 975 825 675

Figure 2. FED’S STOCK VALUATION MODEL (FSVM-1) (ratio scale)

S&P 500 Price Index

1725 1575 1425 1275 1125 975 825

Fair-Value Price*

675

7/26

525

525

375

375

225

225

75

Yardeni

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

75

* 52-week forward consensus expected S&P 500 operating earnings per share divided by 10-year US Treasury bond yield. Monthly through March 1994, weekly after. Source: Thomson Financial.

70 60

Figure 3. FED’S STOCK VALUATION MODEL (FSVM-1)* (percent)

70 60

50

50

40

40

30

30

20

20

Overvalued

10

10

0

0

-10 -20 -30 -40

According to the Fed model, when stock prices are overpriced, returns from stocks are likely to be subpar over the next 12-24 months. Better-than-average returns tend to come from underpriced markets.

-10

Undervalued

-20

7/26 Yardeni

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

-30 -40

* Ratio of S&P 500 Index to its Fair-Value (52-week forward consensus expected S&P 500 operating earnings per share divided by the 10-year US Treasury bond yield) minus 100. Monthly through April 1994, weekly thereafter. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 7

- Valuation Model 18 17

Figure 4. S&P 500 EARNINGS YIELD & BOND YIELD

18 17

16

This chart appeared in the Fed’s July 1997 Monetary Policy Report to the Congress. It shows a very close correlation between the earnings yield of the stock market and the bond yield. Another, more familiar way to look at it follows.

16

15

15

Forward Earnings Yield*

14

14

10-Year US Treasury Bond Yield

13

13

12

12

11

11

10

10

9

9

8

8

7

7/26

7

6

6

5

5

4

4

3 2

3 Yardeni

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

2

* 52-week forward consensus expected S&P 500 operating earnings per share divided by S&P 500 Index. Monthly through March 1994, weekly after. Source: Thomson Financial.

The S&P 500 P/E (using expected earnings) is highly correlated with reciprocal of the bond yield.

26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5

Figure 5. FORWARD P/E & BOND YIELD

7/26 Ratio Of S&P 500 Price To Expected Earnings* Fair-Value P/E=Reciprocal Of Ten-Year U.S. Treasury Bond Yield

Jun Jun Jun Jul Jul Jul Jul

14 21 28 5 12 19 26

Actual 18.1 18.1 17.5 17.1 16.6 15.8 14.9

Fair 20.1 20.7 20.7 20.7 21.2 21.4 22.4 Yardeni

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, weekly after. Source: Thomson Financial.

Page 8 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5

- Earnings 75

70

Figure 6. S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS (analysts’ average forecasts)

75

For 2002

For 2001

70

For 2003

65

65

60

60

Forward Earnings* 7/26

55

55

50

50

45

45

40

Yardeni

I

II

III

IV

I

II

III

IV

I

II

III

Expected forward earnings is a time-weighted average of current and the coming years’ consensus forecasts.

IV

40

2000 2001 2002 * 52-week forward consensus expected S&P 500 operating earnings per share. Time-weighted average of current year and next year’s consensus forecasts. Source: Thomson Financial.

65

Figure 7. S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED

65

60

60

S&P 500 Earnings Per Share ________________________ 55 50

Forward Earnings* (pushed 52-weeks ahead)

45

Operating Earnings (4-quarter sum)

7/25

55 50 45

Q1

40

40

35

35

30

30

25

25

20

20

15

15

10

Yardeni

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Bottom-up 52-week forward expected earnings tends to be a good predicator of actual earnings, with a few significant misses.

10

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, weekly after. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 9

- Earnings 75 70

Figure 8. S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE (analysts’ bottom-up forecasts) Consensus Forecasts __________________ 12-month forward Annual estimates Actual 4Q sum

65 60

75

01

03 99

55

65

00

60

Jul

98

50

70

02

55 50

97 96

45 40

45 40

95

35 91

94

93

92

35

30

30

25

25

20

Analysts always start out too optimistic about the prospects for earnings.

Yardeni

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

20

Source: Thomson Financial.

35

Figure 9. S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE (analysts’ bottom-up forecasts, ratio scale)

30

82

90 30

Consensus Forecasts _________________ 12-month forward Annual estimates Actual 4Q sum

25

35

89 88 85

86

25

87

83 84

20

20

81 80

15

10

15

Yardeni

1978

1979

1980

1981

1982

1983

1984

1985

1986

Source: Thomson Financial.

Page 10 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

1987

1988

1989

1990

1991

10

- Earnings 25

Figure 10. S&P 500 EARNINGS PER SHARE

25

20

20

7/26

15

15

10

10

7/26

5

5

0

The data on consensus expected earnings can be used to derive consensus earnings growth forecasts.

0

-5

-5

Consensus Growth Forecasts* _______________ 2001/2000

-10

-10

2002/2001

-15

-15

2003/2002 -20

Yardeni

I

II

III

IV

I

II

III

IV

I

II

III

IV

-20

2000 2001 2002 * Based on consensus expected S&P 500 operating earnings per share for years shown. Source: Thomson Financial.

Figure 11. S&P 500 OPERATING EARNINGS PER SHARE* 40 (yearly percent change) 45

45 40

35

Actual

35

30

Consensus Forecast (Proforma)*

30

25

Q4

25

20

20

15

15

10

10

5

5

0

0

-5

-5

-10

-10

-15

-15

-20

-20

-25 -30

Earnings growth is highly cyclical.

-25 Yardeni

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

-30

* S&P 500 composition is constantly changing. Actual data are not adjusted for these changes. Proforma forecasts are same-company comparisions. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 11

- New Improved Model 2000

Figure 12. FED’S STOCK VALUATION MODEL (FSVM-2)

2000

1800

1800

This second version of 1600 the Fed’s Stock Valuation Model builds 1400 on the simple one by 1200 adding variables for long-term expected 1000 earnings growth and risk. 800

1600

.25 Actual S&P 500 Fair Value S&P 500* 5-year earnings growth weight _____________ .25 .20 .10

1400

.20

1200 1000

.10 7/26

800

600

600

400

400

200

200

0

Yardeni

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

0

* Fair Value is 12-month forward consensus expected S&P 500 operating earnings per share divided by difference between Moody’s A-rated corporate bond yield less fraction (as shown above) of 5-year consensus expected earnings growth. Source: Thomson Financial 30

Long-term earnings growth expectations rose sharply during 1990s. They fell sharply from 2000-2002.

Figure 13. LONG-TERM CONSENSUS EARNINGS GROWTH* (annual rate, percent)

30

S&P 500 25

25

S&P 500 Information Technology Ex Information Technology

20

20

Jul

15

10

15

Yardeni

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

10

* 5-year forward consensus expected S&P 500 earnings growth. Data from 1995 based on new Global Industry Classification Standard. Source: Thomson Financial.

Page 12 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

- New Improved Model 40

Figure 14. MARKET’S WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH* (percent)

40

35

35

Weight market gives to long-term earnings growth ________________________________________ value > 13% = more than average weight value < 13% = less than average weight

30

30

25

25

20

20

Average = 13% 15

15

Jun 10

10

5

5

0

0

-5

Yardeni

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investors have on average over time subtracted 13% of their long-term earnings growth expectations from the corporate bond yield to determine earnings yield.

-5

* Moody’s A-rated corporate bond yield less earnings yield divided by 5-year consensus expected earnings growth. * Source: Standard and Poor’s Corporation, Thomson Financial and Moody’s Investors Service.

1.6

Figure 15. S&P 500 PEG RATIO

1.6

1.5

1.4

1.5

P/E ratio for S&P 500 divided by 5-year consensus expected earnings growth*

1.4

Jun 1.3

1.2

1.3

Average = 1.2

1.2

1.1

1.1

1.0

1.0

.9

.9

.8

Yardeni

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Historically, S&P 500 sold at P/E of 1.2 times long-term expected earnings growth, on average, with quite a bit of volatility.

.8

* P/E using 12-month forward consensus S&P 500 expected earnings and prices at mid-month. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 13

- New Improved Model 12

Figure 16. CORPORATE BOND YIELD (percent)

12

11

11

10

10

A-Rated

9

9

8

8

7/26

7

6

Corporate bond yield variable in FSVM-2 captures risk that earnings will be weaker than expected.

7

Yardeni

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

6

Source: Moody’s Investors Service.

400

Figure 17. CORPORATE SPREAD* (basis points)

400

350

350

300

300

Moody’s A-Rated Corporate Bond Yield Minus 10-Year US Treasury Bond Yield

7/26

250

250

200

200

150

150

100

100

Average = 131 50

0

50 Yardeni

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

* Monthly through 1994, weekly thereafter. Source: Board of Governors of the Federal Reserve System and Moody’s Investor Service.

Page 14 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

0

- Global: Expected Earnings* -

Figure 18. 65

UNITED STATES (S&P 500)

325

GERMANY (DAX)

300

60

275

Jul

55

Jul

50 45

250 225

Expected EPS* (dollars)

Expected EPS (euros)

200 175

40

150 35 125 30 25

550 525

100 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

CANADA (TSE 300)

FRANCE (CAC 40)

280 260

500

240

475

400

Expected EPS (euros)

Jul

450 425

75

Expected EPS (Canadian dollars)

Jul

220 200

375

180

350 160

325 300

140

275

120

250 225

360

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

UNITED KINGDOM (FT 100)

JAPAN (TOPIX)

100

70

340 60

320 300

Expected EPS (pounds)

Expected EPS (yen)

50

280

Jul

260

40

240 220

Jul

30

200 180

Yardeni

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

20

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 15

- Global: Stock Valuation Figure 19. 80 60

80

UNITED STATES

60

Overvalued

40

40

20

20

0 -20 -40 50

0

Jun

-20

Undervalued 1995

1996

1997

1998

1999

2000

2001

2002

2003

50

CANADA Overvalued

30

30

10

10

Jun

-10 -30 40

1995

1996

1997

1998

1999

2000

2001

2003

20

Jun

0 -20

Undervalued 1995

1996

1997

1998

1999

2000

2001

2002

2003

60

Overvalued

40

20

20

0 -20

60

Undervalued 1995

1996

1997

1998

0

Jun 1999

2000

2001

2002

-20 2003

40

Overvalued

20

20

0

150

1995

1996

1997

1998

0

Jun

Undervalued

-20

200

-40 60

FRANCE

40

-40

-40 80

GERMANY

40

-40

-30 40

Overvalued

-20

60

2002

UNITED KINGDOM

0

80

-10

Undervalued

20

-40

-40

-20 1999

2000

2001

2002

2003

-40 200

JAPAN

150

100

100

Overvalued

50

50

0

0

-50 -100

Undervalued

Yardeni

1995

1996

1997

-50

Jun 1998

1999

2000

Source: Thomson Financial. Page 16 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

2001

2002

2003

-100

- Global: United States (S&P 500) -

Figure 20. 160

70

STOCK VALUATION MODEL

150

60

140

Jul

130

50

Industrial Production (1987=100)

120

40

110 100

30

90

Expected Earnings Per Share* For S&P 500 (dollars)

80 70

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

20

99

00

01

02

03

04

10

30

30

25

25

Fair-Value P/E 20

Jun

Forward P/E

20

15

15

10

10

5

79

80

81

1825 1475 1125

82

83

84

85

86

87

775

Stock Price Index (S&P 500) (ratio scale)

425

Fair-Value Price (ratio scale)

75 70 60 50 40 30 20 10 0 -10 -20 -30 -40

79

80

81

82

83

84

85

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

1825 1475 1125

Jun

775 425

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

Overvalued

Jun Undervalued 79

80

81

82

83

84

85

5

86

87

88

89

90

91

92

93

Yardeni

94

95

96

97

98

99

00

01

02

03

04

75 70 60 50 40 30 20 10 0 -10 -20 -30 -40

Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 17

- Global: Canada (TSE 300) -

Figure 21. 120

STOCK VALUATION MODEL

115

Apr

Expected Earnings Per Share for TSE 300 (Canadian dollars)

110

Jul

105 100 95 90

Industrial Production (1997=100)

85 80 75

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

24

550 525 500 475 450 425 400 375 350 325 300 275 250 225 24

22

22

Fair-Value P/E Forward P/E

20

20

18

18

Jun

16

16

14

14

12

12

10

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

12500

12500

10500 8500

Stock Price Index (TSE 300) (ratio scale)

6500

Fair-Value (ratio scale)

10500 8500

Jun 6500

4500

2500

10

4500

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2500

50

50

40

40

30

30

Overvalued

20

20

10

10

0

0

Jun

-10

Undervalued

-20 -30

-10 -20 Yardeni

1993

1994

1995

1996

1997

1998

1999

2000

* Source: Thomson Financial.

Page 18 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

2001

2002

2003

-30

- Global: United Kingdom (FT 100) -

Figure 22. 110

350

STOCK VALUATION MODEL

105

300

100

Industrial Production (1995=100)

250

95

Jul

85

200

Expected Earnings Per Share for FT 100 (pounds)

90

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

150

25

25

23

23

21

21

Fair-Value P/E

19

Jun

19

Forward P/E

17

17

15

15

13

13

11

11

9

9

7

1988

1989

7900 7100 6300 5500

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

7900 7100 6300 5500

Stock Price Index (FT 100) (ratio scale)

4700

Jun

Fair-Value (ratio scale)

3900

7

4700 3900

3100

3100

2300

2300

1500

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1500

40

40

30

30

20

20

Overvalued

10

10

Jun

0

0

-10

-10

Undervalued -20 -30

-20 Yardeni

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

-30

Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 19

- Global: Germany (DAX) -

Figure 23. 120

325

STOCK VALUATION MODEL

300 275

110

250

Jul

Industrial Production (1995=100)

225 200 175

100

150

Expected Earnings Per Share for DAX (Euros) 90 34 32 30 28 26 24 22 20 18 16 14 12 10 8

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

125 100 2002

2003

2004

Fair-Value P/E Forward P/E Jun

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

11000 9000

34 32 30 28 26 24 22 20 18 16 14 12 10 8 11000 9000

7000

7000

Stock Price Index (DAX) (ratio scale)

5000

5000

Jun

Fair-Value (ratio scale) 3000

1000

75

3000

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1000

80

80

60

60

Overvalued

40

40

20

20

0

0

Jun -20 -40

-20

Undervalued Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Source: Thomson Financial.

Page 20 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

2001

2002

2003

2004

-40

- Global: France (CAC 40) -

Figure 24. 120 118 116 114 112 110 108 106 104 102 100 98

275

STOCK VALUATION MODEL

250 225

Jul

200

Industrial Production (1995=100)

175 150

Expected Earnings Per Share for CAC 40 (Euros) 1995

1996

1997

1998

1999

2000

125 2001

2002

2003

29

100 29

27

27

25

Fair-Value P/E

25

23

Forward P/E

23

21

21

Jun

19

19

17

17

15

15

13

13

11

1995

1996

1997

1998

1999

2000

2001

2002

2003

7900 7100 6300 5500

7900 7100 6300 5500

Stock Price Index (CAC 40) (ratio scale)

4700 3900

4700

Jun

3900

Fair-Value (ratio scale)

3100

3100

2300

1500

11

2300

1995

1996

1997

1998

1999

2000

2001

2002

2003

1500

60

60

40

40

Overvalued

20

20

0

0

Undervalued

-20 -40

Jun -20 Yardeni

1995

1996

1997

1998

1999

2000

2001

2002

2003

-40

Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 21

- Global: Japan (TOPIX) -

Figure 25. 115

60

STOCK VALUATION MODEL

110

Expected Earnings Per Share for TOPIX (yen)

105

Industrial Production (1995=100)

50

Jul 40

100

Jun

30

95 90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

150

20 150

Fair-Value P/E 100

100

Forward P/E Jun

50

0

50

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

0

4500

4500

4000

4000

3500

3500

3000

3000

Stock Price Index (TOPIX)

2500

2500

Fair-Value

2000

2000

1500

1500

Jun

1000

1000

500 0

500 1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

0

300

300

200

200

Overvalued 100

100

0

0

Undervalued Jun -100

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Source: Thomson Financial.

Page 22 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

2001

2002

Yardeni

2003

2004

-100

- Earnings: US vs G5 65

Figure 26. S&P 500 & G5 FORWARD EARNINGS

300

60

S&P 500 Forward Earnings* 7/26

55

G5 Forward Earnings**

250

Jul

50

45

200

40

35

150

30

25

Yardeni

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

100

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, weekly after. ** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada, France, Germany, Japan and United Kingdom. Source: Thomson Financial. 30

Figure 27. S&P 500 & G5 FORWARD EARNINGS (yearly percent change)

Close correlation between US and G5 profits cycle.

30

20

20

10

10

Jul

0

0

-10

-10

Jul S&P 500 Forward Earnings*

-20

-20

G5 Forward Earnings** -30

Yardeni

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

-30

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial. ** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada, France, Germany, Japan and United Kingdom. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 23

- Earnings & Output: US 65

Figure 28. S&P 500 EARNINGS & INDUSTRIAL PRODUCTION

160

60

150

7/26 Jun

55 50

S&P 500 Forward Earnings*

45

Industrial Production (1992=100)

140 130

40

120

35

110

30

100

25 90 20 80

15 10

Strong correlation between US industrial production and S&P 500 forward earnings.

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

70

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, weekly after Source: Thomson Financial.

30 25

Figure 29. S&P 500 EARNINGS & PRODUCTION (yearly percent change)

30 25

20

20

15

15

10

10

5

5

7/26

0 -5 -10

-5

S&P 500 Forward Earnings* Industrial Production

-15 -20

0

-10 -15

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, weekly after Source: Thomson Financial.

Page 24 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

-20

- Earnings & Prices: US 30 25

Figure 30. S&P 500 EARNINGS & PRODUCER PRICE INDEX (yearly percent change)

30 25

20

20

15

15

10

10

5

5

7/26

0

0

Jun -5

-5

PPI: Intermediate Goods

-10

-10

S&P 500 Forward Earnings* -15 -20

-15 Yardeni

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

-20

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.

25

Figure 31. S&P 500 EARNINGS & US IMPORT PRICES (yearly percent change)

25

20

20

Import Price Index S&P 500 Forward Earnings*

15

15

10

10

5

5

7/26

0

Jun

-5

0 -5

-10

-10

-15

-15

-20

Yardeni

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Profits cycle is highly correlated with pricing cycles especially with the intermediate goods PPI and import prices.

2002

2003

-20

* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial, US Department of Labor, Bureau of Labor Statistics.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 25

- Earnings & Output: Europe 120

Figure 32. FRANCE: EARNINGS & PRODUCTION

275

118

May

116

250

114

Forward Earnings*

112

225

Jul

Industrial Production (1995=100)

110 108

200

106 104

175

102 100

150

98 96

125

94 92

Industrial production is key variable driving profits in France and UK.

Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

100

* 12-month forward consensus expected earnings per share for CAC 40. Source: Thomson Financial.

110

Figure 33. UNITED KINGDOM: EARNINGS & PRODUCTION

340

108 320 106 300

104

May

102

280

100 260 98

Forward Earnings*

240

96

Industrial Production (1995=100)

94

Jul

220

92 200 90 88

Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

* 12-month forward consensus expected earnings per share for FT 100. Source: Thomson Financial.

Page 26 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models

2000

2001

2002

2003

180

- Earnings & Output: Japan 115

Figure 34. JAPAN: EARNINGS & PRODUCTION

60

Forward Earnings*

110

50

Industrial Production (1995=100) Jul

105

40 100

Jun

30

95

90

Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

20

Japan’s profits cycle driven by manufacturing.

* 12-month forward consensus expected operating earnings per share for TOPIX. Source: Thomson Financial.

100

Figure 35. JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS

75

Forward Earnings*

50

Tankan Business Conditions: Major Manufacturers (diffusion index)

60

50

Jul 25

40

0 30 -25

Q1 -50

Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

20

* 12-month forward consensus expected earnings per share for TOPIX. Source: Thomson Financial.

Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 27

RESEARCH

The research analyst(s) or a member of the research analyst’s household does not have a financial interest in any of the tickers mentioned in this report. The research analyst or a member of the team does not have a material conflict of interest relative to any stock mentioned in this report The research analyst has not received compensation that is based upon (among other factors) the firm’s investment banking revenues as it related to any stock mentioned in this report The research analyst, a member of the team, or a member of the household do not serve as an officer, director, or advisory board member of any stock mentioned in this report Prudential Securities has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of 15% or more over the next 12 to 18 months. For higher risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline 15% or more over the next 12 to 18 months. For lower risk stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell. Rating distribution 07/15/02 Buy Hold Sell Excludes Closed End Funds

Firm 40.00% 56.00% 3.00%

IBG Clients 4.00% 5.00% 1.00%

Any OTC-traded securities or non-U.S. companies mentioned in this report may not be cleared for sale in all states.

50.00% 50.00% 0.00%

02-XXXX

Securities products and services are offered through Prudential Securities Incorporated, a Prudential company. ©Prudential Securities Incorporated, 2002, all rights reserved. One Seaport Plaza, New York, NY 10292 Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such information has not been verified by us, and we do not make any representations as to its accuracy or completeness. Any statements nonfactual in nature constitute only current opinions, which are subject to change. Prudential Securities Incorporated (or one of its affiliates or subsidiaries) or their officers, directors, analysts, employees, agents, independent contractors, or consultants may have positions in securities or commodities referred to herein and may, as principal or agent, buy and sell such securities or commodities. An employee, analyst, officer, agent, independent contractor, a director, or a consultant of Prudential Securities Incorporated, its affiliates, or its subsidiaries may serve as a director for companies mentioned in this report. Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation of an offer to buy any securities or commodities mentioned herein. There may be instances when fundamental, technical, and quantitative opinions may not be in concert. This firm (or one of its affiliates or subsidiaries) may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange rate fluctuations, and limited availability of information on international securities. Prudential Securities Incorporated, its affiliates, and its subsidiaries make no representation that the companies which issue securities which are the subject of their research reports are in compliance with certain informational reporting requirements imposed by the Securities Exchange Act of 1934. Sales of securities covered by this report may be made only in those jurisdictions where the security is qualified for sale. The contents of this publication have been approved for distribution by Prudential-Bache International Limited, which is regulated by The Securities and Futures Authority Limited. We recommend that you obtain the advice of your Financial Advisor regarding this or other investments.

Additional information on the securities discussed herein is available upon request.