R e s e a r c h

July 30, 2002

Asset Valuation & Allocation Models

Dr. Edward Yardeni (212) 778-2646 ed_yardeni@prusec.com Amalia F. Quintana (212) 778-3201 mali_quintana@prusec.com

- Introduction I. Feds 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, its good enough for me. I dubbed it the Feds 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 didnt 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 markets exuberance. Apparently, they did so and it was made public, though buried, in the Feds Monetary Policy Report to the Congress, which accompanied Mr. Greenspans 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 Feds valuation model: 2) FVP = E/TBY
1 2

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

Excerpt from Feds 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 years 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 pricesthe old fashioned way to decrease values. Undervaluation can be corrected by rising yields, lower earnings expectations, or higher stock prices. The Feds 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 markets 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 wont be sufficient to meet the debt-servicing obligations of some companies. Most companies wont 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 Moodys 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). Ive 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

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

80 70 60 50 40

ED YARDENIS ASSET ALLOCATION MODEL: BONDS/STOCKS* (for Moderately Aggressive Investor) Stocks overvalued when greater than zero Stocks undervalued when less than zero

80 70 60 50 40

- Asset Allocation -

70/30
30 30

50/50
20 20

40/60
10 10

30/70
0 -10 -20 -30 -40

30/70 20/80 10/90 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.

- Valuation Model 1725 1575 1425 1275 1125 975 825 675 525 375

Figure 2. FEDS STOCK VALUATION MODEL (FSVM-1) (ratio scale)

7/26

S&P 500 Price Index Fair-Value Price*

1725 1575 1425 1275 1125 975 825 675 525 375

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 50 40 30 20 10 0 -10 -20 -30 -40

Figure 3. FEDS STOCK VALUATION MODEL (FSVM-1)* (percent)

70 60 50 40 30

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.

Overvalued

20 10 0 -10

Undervalued

-20

7/26
Yardeni

-30 -40

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

* 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 16

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

18 17 16

This chart appeared in the Feds 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.

15 14 13 12 11 10 9 8 7 6 5 4 3 2

Forward Earnings Yield* 10-Year US Treasury Bond Yield

15 14 13 12 11 10 9 8

7/26

7 6 5 4 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

* 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

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

* 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

- Earnings 75

Figure 6. S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS (analysts average forecasts) For 2001 For 2002 For 2003

75

70

70

65

65

60

Forward Earnings* 7/26

60

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

55

55

50

50

45
Yardeni

45

40

II

III

IV

II

III

IV

II

III

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 years consensus forecasts. Source: Thomson Financial.

65 60

Figure 7. S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED S&P 500 Earnings Per Share ________________________

65 60

55 50 45 40 35 30 25 20 15 10

7/25

Forward Earnings* (pushed 52-weeks ahead) Operating Earnings (4-quarter sum) Q1

55 50 45 40 35 30 25 20 15

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

Yardeni

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

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 65 60 55 50 45 40 35 91 30 25 20
Yardeni

Figure 8. S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE (analysts bottom-up forecasts) Consensus Forecasts __________________ 12-month forward Annual estimates Actual 4Q sum 98 97 96 95 92 93 94

75

01

02 03

70 65 60

99

00 Jul

55 50 45 40 35 30 25 20

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Analysts always start out too optimistic about the prospects for earnings.
35

Source: Thomson Financial.

Figure 9. S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE (analysts bottom-up forecasts, ratio scale) Consensus Forecasts _________________ 12-month forward Annual estimates Actual 4Q sum 82 83 84 81 80 89 88 85 86 87

35

90
30

30

25

25

20

20

15

15

10

Yardeni

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

10

Source: Thomson Financial.

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

- Earnings 25 20 15 10 5 0 -5 -10 -15 -20

Figure 10. S&P 500 EARNINGS PER SHARE 7/26

25 20 15 10

7/26

5 0 -5 -10 -15
Yardeni

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

Consensus Growth Forecasts* _______________ 2001/2000 2002/2001 2003/2002

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 35 30 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30
Yardeni

45 40 35 30

Actual Consensus Forecast (Proforma)* Q4

25 20 15 10 5 0 -5 -10 -15 -20 -25

Earnings growth is highly cyclical.

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 1800

Figure 12. FEDS STOCK VALUATION MODEL (FSVM-2)

2000 1800 1600

This second version of 1600 the Feds Stock Valuation Model builds 1400 on the simple one by 1200 adding variables for long-term expected 1000 earnings growth and risk. 800
600 400 200 0

.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

800 600 400 200

Yardeni

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

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

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

30

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

S&P 500
25 25

S&P 500 Information Technology Ex Information Technology

20

20

Jul

15

15

10

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 35 30 25 20

Figure 14. MARKETS WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH* (percent) Weight market gives to long-term earnings growth ________________________________________ value > 13% = more than average weight value < 13% = less than average weight

40 35 30 25 20

Average = 13%
15 15

Jun
10 5 0 -5
Yardeni

10 5 0 -5

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

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

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

1.6

Figure 15. S&P 500 PEG RATIO

1.6

1.5

1.5

1.4

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

1.4

1.3

1.3

1.2

Average = 1.2

1.2

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.

1.1

1.1

1.0

1.0

.9
Yardeni

.9

.8

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

.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

A-Rated

10

7/26

Yardeni

Corporate bond yield variable in FSVM-2 captures risk that earnings will be weaker than expected.
400

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: Moodys Investors Service.

Figure 17. CORPORATE SPREAD* (basis points)

400

350

350

300

300

Moodys A-Rated Corporate Bond Yield Minus 10-Year US Treasury Bond Yield
250

7/26

250

200

200

150

150

100

100

Average = 131
50
Yardeni

50

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 Moodys Investor Service.

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

Figure 18.
65 60 55 50 45 40 35

- Global: Expected Earnings* GERMANY (DAX) Jul Jul

325 300 275 250 225

UNITED STATES (S&P 500)

Expected EPS* (dollars)

Expected EPS (euros)

200 175 150 125

30 25 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

100 75

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

CANADA (TSE 300)

FRANCE (CAC 40)

280 260 240

Jul Expected EPS (Canadian dollars)

Expected EPS (euros)

Jul

220 200 180 160 140 120

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

100

360 340 320 300 280 260 240 220 200 180

UNITED KINGDOM (FT 100)

JAPAN (TOPIX)

70

60

Expected EPS (pounds)

Expected EPS (yen) Jul

50

40

Jul

30
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 40 20 0 -20 -40 50 30 10 -10 -30 40 20 0 -20 -40 80 60 40 20 0 -20 -40 60 40 20 0 -20 -40 200 150 100 50 0 -50 -100
Yardeni

UNITED STATES Overvalued

80 60 40 20 0 -20 2003 -40 50

Jun Undervalued
1995 1996 1997 1998 1999 2000 2001 2002

CANADA Overvalued

30 10

Jun Undervalued
1995 1996 1997 1998 1999 2000 2001 2002 2003

-10 -30 40

UNITED KINGDOM Overvalued Jun Undervalued

1995 1996 1997 1998 1999 2000 2001 2002 2003

20 0 -20 -40 80 60

GERMANY Overvalued

40 20 0 -20 2003 -40 60 40

Undervalued
1995 1996 1997 1998 1999 2000 2001

Jun
2002

FRANCE Overvalued Jun

20 0 -20 1999 2000 2001 2002 2003 -40 200 150 100 50 0 -50 2003 -100

Undervalued
1995 1996 1997 1998

JAPAN Overvalued

Undervalued
1996 1997 1998 1999 2000 2001

Jun
2002

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

1995

Figure 20.
160 150 140 130 120 110 100 90 80 70 30 25 79 80 81 82 83 84

- Global: United States (S&P 500) 70 60

STOCK VALUATION MODEL Jul Industrial Production (1987=100)

50 40 30

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

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

20 10 30 25

Fair-Value P/E
20 15 10 5 1825 1475 1125 775 425

Forward P/E

Jun

20 15 10 5 1825 1475 1125 775 425

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

Stock Price Index (S&P 500) (ratio scale) Fair-Value Price (ratio scale)

Jun

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

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

Overvalued

Jun Undervalued
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Yardeni

02

03

04

Source: Thomson Financial.

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

Figure 21.
120 115 110 105 100 95 90 85 80 75 24 22 20 18 16 14 12 10 12500 10500 8500 6500 1993 1994 1995 1991 1992 1993 1994

- Global: Canada (TSE 300) Expected Earnings Per Share for TSE 300 (Canadian dollars) Apr Jul
550 525 500 475 450 425 400 375 350 325 300 275 250 225 24

STOCK VALUATION MODEL

Industrial Production (1997=100)

1995

1996

1997

1998

1999

2000

2001

2002

2003

Fair-Value P/E Forward P/E Jun

22 20 18 16 14 12

1996

1997

1998

1999

2000

2001

2002

2003

10 12500

Stock Price Index (TSE 300) (ratio scale) Fair-Value (ratio scale) Jun

10500 8500 6500

4500

4500

2500 50 40 30 20 10 0 -10 -20 -30

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2500 50 40 30

Overvalued

20 10 0

Jun Undervalued
Yardeni

-10 -20

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

-30

* Source: Thomson Financial.

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

Figure 22.
110 105 100 95 90 85 25 23 21 19 17 15 13 11 9 7 7900 7100 6300 5500 4700 3900 3100 2300 1988 1989 1990 1991

- Global: United Kingdom (FT 100) 350 300

STOCK VALUATION MODEL

Industrial Production (1995=100) Jul Expected Earnings Per Share for FT 100 (pounds)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

250

200

150 25 23

Fair-Value P/E Forward P/E

21

Jun

19 17 15 13 11 9

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

7 7900 7100 6300 5500

Stock Price Index (FT 100) (ratio scale) Fair-Value (ratio scale) Jun

4700 3900 3100 2300

1500 40 30 20 10 0 -10

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1500 40 30

Overvalued Jun

20 10 0 -10

Undervalued
-20 -30
Yardeni

-20 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

Figure 23.
120

- Global: Germany (DAX) 325 300 275 250 225 200 175

STOCK VALUATION MODEL

110

Industrial Production (1995=100)

Jul

100

150

Expected Earnings Per Share for DAX (Euros)

90 34 32 30 28 26 24 22 20 18 16 14 12 10 8 11000 9000 7000 5000 3000 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

125 100 75 34 32 30 28 26 24 22 20 18 16 14 12 10 8 11000 9000

Fair-Value P/E Forward P/E Jun

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Stock Price Index (DAX) (ratio scale) Fair-Value (ratio scale) Jun

7000 5000 3000

1000 80 60 40 20 0

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1000 80 60

Overvalued

40 20 0

Jun
-20 -40

Undervalued
Yardeni

-20 -40

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Source: Thomson Financial.

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

Figure 24.
120 118 116 114 112 110 108 106 104 102 100 98 29 27 25 23 21 19 17 15 13 11 7900 7100 6300 5500 4700 3900 3100 2300 1995 1996 1997

- Global: France (CAC 40) 275 250

STOCK VALUATION MODEL

Jul Industrial Production (1995=100) Expected Earnings Per Share for CAC 40 (Euros)
1995 1996 1997 1998 1999 2000 2001 2002 2003

225 200 175 150 125 100 29 27

Fair-Value P/E Forward P/E Jun

25 23 21 19 17 15 13 1998 1999 2000 2001 2002 2003 11 7900 7100 6300 5500

Stock Price Index (CAC 40) (ratio scale) Fair-Value (ratio scale)

4700

Jun

3900 3100 2300

1500 60 40 20 0 -20 -40

1995

1996

1997

1998

1999

2000

2001

2002

2003

1500 60 40

Overvalued

20 0

Undervalued

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

Figure 25.
115 110 105 100

- Global: Japan (TOPIX) 60

STOCK VALUATION MODEL Expected Earnings Per Share for TOPIX (yen) Industrial Production (1995=100) Jul

50

40

Jun
95 90 150

30

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

20 150

Fair-Value P/E
100

Forward P/E Jun

100

50

50

0 4500 4000 3500 3000 2500 2000 1500 1000 500 0 300

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

0 4500 4000 3500

Stock Price Index (TOPIX) Fair-Value

3000 2500 2000 1500

Jun

1000 500

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

0 300

200

200

Overvalued
100 100

Undervalued Jun
-100 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Yardeni

2004

-100

Source: Thomson Financial.

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

- Earnings: US vs G5 65

Figure 26. S&P 500 & G5 FORWARD EARNINGS

300

60

S&P 500 Forward Earnings*

55

7/26 G5 Forward Earnings** Jul

250

50

45

200

40

35

150

30
Yardeni

25

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

Close correlation between US and G5 profits cycle.

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

30

20

20

10

10

Jul

-10

-10

Jul
-20

S&P 500 Forward Earnings* G5 Forward Earnings**

-20

-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 60 55 50 45 40 35 30 25 90 20 15 10 80 70

Figure 28. S&P 500 EARNINGS & INDUSTRIAL PRODUCTION

160 150

7/26 Jun S&P 500 Forward Earnings* Industrial Production (1992=100)

140 130 120 110 100

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

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

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

30 25 20 15 10 5 0 -5 -10 -15 -20

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

30 25 20 15 10 5

7/26

0 -5

S&P 500 Forward Earnings* Industrial Production

-10 -15 -20

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

- Earnings & Prices: US 30 25 20 15 10 5 0 -5 -10 -15 -20

Yardeni

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

30 25 20 15 10 5

7/26 Jun

0 -5

PPI: Intermediate Goods S&P 500 Forward Earnings*

-10 -15 -20

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

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

25 20 15 10 5 0 -5 -10 -15 -20

Figure 31. S&P 500 EARNINGS & US IMPORT PRICES (yearly percent change) Import Price Index S&P 500 Forward Earnings*

25 20 15 10 5

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

7/26 Jun

0 -5 -10 -15

Yardeni

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

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 120 118 116 114 112 110 108 106 104 102 100 98 96 94 92
Yardeni

Figure 32. FRANCE: EARNINGS & PRODUCTION May

275

250

Forward Earnings* Industrial Production (1995=100) Jul

225

200

175

150

125

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

100

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

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

110 108

Figure 33. UNITED KINGDOM: EARNINGS & PRODUCTION

340

320 106 104 102 100 260 98 300

May

280

Forward Earnings*
96 94 92

240

Industrial Production (1995=100)

Jul

220

200 90 88
Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

180

* 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

- Earnings & Output: Japan 115

Figure 34. JAPAN: EARNINGS & PRODUCTION

60

110

Forward Earnings* Industrial Production (1995=100)

50

105

Jul
40

100

Jun
95

30

90

Yardeni

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

20

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

Japans profits cycle driven by manufacturing.

60

100

Figure 35. JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS Forward Earnings* Tankan Business Conditions: Major Manufacturers (diffusion index) Jul

75

50

50

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 analysts 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 firms 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%

50.00% 50.00% 0.00%

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

02-XXXX

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