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THE ECONOMY AND THE THE ECONOMY AND THE CAPITAL MARKETSCAPITAL MARKETS
University of ConnecticutSchool of Business
Robert F. DeLuciaMarch 26, 2004
2
AGENDA
Introduction and Overview
Identifying Critical Economic Forces
Economic Outlook Summary
Broad Capital Market Implications
In-Depth Equity Market Analysis
Equity Market Valuation Factors
Major Systematic Risks to the Forecasts
Individual Stock Selection
3
INTRODUCTION
CIGNA Retirement & Investment Services
Prudential Retirement
Economic Function and Mission
Philosophy and Methodology
Investment vs. Speculation
Emphasis on Economic Fundamentals
Emphasis on Government Economic Policy
Intrinsic Value Foundation
4
PRIMARY ECONOMIC FORCES
Unprecedented Federal Reserve Monetary Stimulus
Pro-Growth / Pro-Investment Tax Policy
Transformation of the U.S. Corporate Sector Balance Sheet, Finances, and Profitability
Declining U.S. Dollar Exchange Rate
5
OTHER SIGNIFICANT ECONOMIC FORCES
Global Central Bank Monetary Stimulus, Particularlyin Asia
Rapid Pace of Technological Innovation
Unprecedented Growth in Labor Productivity
Highly Favorable Credit Market Conditions
Globalization and Increasingly Free Markets
Asian Economic Boom Led by Industrialization of China
Schumpeterian Waves of “Creative Destruction”
6
ECONOMIC OUTLOOK: MAJOR CONCLUSIONS
Above-Trend Economic Growth 2004 – 2005
Economic Sector Leadership: Capital Goods, Exports, and Basic Manufacturing
Continued Rising Corporate Profitability
Mild Acceleration in Inflation 2004 – 2005
Global Economic Recovery
Steadily Rising Interest Rates Beginning in Second Half of 2004 and well into 2005
7
CAPITAL MARKET IMPLICATIONS: SUMMARY
Economic Trends and Policy Remain Favorable for Equity Markets
Bear Market for Fixed Income During 2004 – 2005 Period
Further Dollar Depreciation, Primarily Against the Asian Currencies
Within Equity Markets, Most Favorable:
Large Capitalization Stocks
Highest Quality Industry Leaders
Favorable Dividend Prospects
U.S. Multinationals
Non-Dollar Markets and Emerging Asia
8
EQUITY MARKET ANALYSIS: BASIC PRINCIPLES
Corporate Sector Fundamentals
Earnings, Cash Flow, Dividends
Balance Sheets
Corporate Governance
Equity Market Valuation
Quantitative Factors
Qualitative Factors
In Short: Ability of Corporations to Grow Earnings and Dividends, and Market Capitalization Factors
9
EQUITY MARKET VALUATION FACTORS:CAPITALIZATION RATES
Inflation
Interest Rates
Liquidity / Yield Curve / Federal Reserve Policy
Tax Policy
U.S. Dollar
Dividend Pay-Out Ratios
Quality of Reported EPS
Stability of Economic Growth
Geopolitical Developments
Government Economic Policies
10
EQUITY MARKET VALUATION, INTEREST RATES, AND INFLATION
Average P/E Ratio
Average Annual
CPI
Market Yield10-Year
Treasury Note
1960 - 1972 17.0 x + 2.8% 5.25%
1973 - 1984 9.5 + 8.0 9.75
1985 - 1996 15.5 + 3.5 7.75
1997 - 2003 24.0 + 2.3 5.25
1960 - 2003 Average 16.0 x + 4.3% 7.25%
Current Market 18.0 x + 1.7% 3.75%
11
MAJOR RISKS TO THE OUTLOOK
The War on Terrorism
Geopolitical / Middle East Instability
Energy Supply / Costs
Rising Inflation Leads to Premature Monetary Squeeze
U.S. Dollar / Foreign Exchange Crisis
Bond Market Collapse
Trade Protectionism
Boom / Bust Cycle in China
12
SUMMARY AND MAJOR CONCLUSIONS
Prevailing Government Economic Policies and Business Cycle Forces Favorable for Equity Markets
Bonds are in Early Phase of a Multi-Year Bear Market
Further U.S. Dollar Depreciation Likely 2004 – 2005
Equity Market is No Longer Cheap but also Not Statistically Overvalued
Regional and Market Sector Opportunities Exist
Individual Stock Selection More Important Than Ever
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