MPSIF Economic Update

1. MPSIF Economic Update April 5th, 2004 Stern School of Business New York University

2. Market Trends: Quarter RecapBig markets flat; Small caps continue to outperform • Dow Jones Industrial Average ↓ 0.91% • S&P 500 ↑ 1.29% • NASDAQ Composite ↓ 0.84% since Annual Report • Russell 2000 Index ↑ 6.00% • 1Q04 earnings expected to be up 17% yoy (above estimate) • March 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 Friday (rate went up .29% in one day!)

3. Economic Fundamentals – Trends and Estimates • Fed Rate: • Jobs report increases probability of a Fed increase this summer • 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% the day before the jobs report • But, these probabilities are down from February, when futures prices were predicting 72% chance of a 25bp increase by July and a 100% chance of a 50bp increase by November • Triggers are inflation gap and GDP gap… and election? • GDP: • 4.1% increase in 4Q03. • Analysts continue to expect 4.5% for 2004. • Inflation: • Reached a 40 year low of 1.1% in November, expected to rise to 2.0% November 2004 • Import prices have risen 5 consecutive months, but still low. • Capacity utilization remains low, but rising.

4. Employment Report • March Unemployment Rate 5.7%, up from 5.6% • Nonfarm payrolls increased 308,000 • largest gain since April 2000 • 1st month in 44 mfg jobs did not  • 230K of jump from services • Signal that more formerly discouraged workers looking for jobs • Hourly earnings  measly .1% • Annual rate 1.8% • Average workweek 33.7 hours, down a bit from 33.8

5. Crude Oil Oil and Gas Outlook • OPEC cut production quota by 1 mbbl/d in anticipation of seasonal demand reduction • Until April 1st, OPEC production at 26 mbbl/day • OPEC committed to reduce by 1.5 mbbl/d “cheating” ineffective • Decision to cut production contentious within OPEC; Saudis supportive • OPEC under pressure from U.S. administration • Natural pas prices remain high (supply and demand imbalance) • Oil and gas one-month futures prices dropped Friday by 3-4% • Caused by strengthened dollar and comments by Kuwaiti and Saudi oil ministers Conclusion: Oil tough to call; gas prices likely to remain strong

6. U.S. Currency Markets • Friday’s payroll announcement strengthened dollar relative to euro • ECB continues to focus on inflationary pressures, maintaining higher interest rates • Dollar has strengthened against the yen in last three weeks • Japan had purchased 2/3 (~¥3.5 t) of its 2003 total through March • Indications that intervention slowed dramatically in late-March • Japanese and Chinese intervention in currency markets has helped finance U.S.’s current account and budget deficits • Conclusion: Increasing growth and subsequent increase in interest rates will lesson support for exporters in near-term; influence unlikely to be felt until 2005

7. Fixed Income Outlook • Approx. 28% of fund assets are in bond funds • Fund charter requires securities to be investment grade • ~1/3 each in treasuries, mortgages, and corporate bonds • Most spreads over treasuries are below historical level • While interest rates stay low, continue receiving coupons • However, as rates increase over next year, capital losses likely • Recommendation • Reduce fixed income holdings (if possible) • Rotate into inflation-protected bonds (e.g., TIPS)

8. Fall Presidential Elections • Bush/Kerry futures on IEM at 0.52/0.48 • As is typical, business supporting Republican over Democrat • Proportion more lopsided toward Bush than at the end of the Bush/Gore race • Kerry’s “Jobs First” plan focuses on: • Tax incentives for companies that create jobs domestically • Slowing the export of jobs abroad • Assisting manufacturing sector  Intends to increase taxes on wealthy • Bush has not outlined any significant deviations from current policies • Has alluded to make U.S. market less litigious (e.g., cap on malpractice awards) • More sensitive industries: legal, real estate, securities & investment, medical • Conclusion: Bush likely more favorable for global businesses; Kerry for U.S. manufacturing

9. Sector Recommendations • Overweight: Financials (large cap), Energy, Industrials, Materials, IT, Consumer Discretionary • Neutral: Health Care, Telecom, Technology, Utilities • Underweight: Financials (small cap) Consumer Staples

10. Revisiting the question: Are stocks overvalued? An interesting take from a value perspective • Robert Weigand and Robert Irons study suggests that high P/E ratios are no longer mean reverting or indicative of negative future returns. • They also find that high P/E ratios (above 21) have been associated with the highest average of 10 year earnings growth, and a positive 10 year rate of returns, going back to 1881. • It seems that interest rates, at least since 1960, are a better predictor of earnings and returns. • All of this suggests P/E ratios can deviate from the historical mean for long periods of time, or even permanently.

11. While P/E ratios have deviated significantly from their historical mean… Source: Weingand & Irons, The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion

12. …E/P ratios have become cointegrated with 10-year Yield Source: Weingand & Irons, The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion

13. E/P ratios and 10-year yield – what it all means for investors • The 10-year rate and E/P ratios are highly, and positively correlated, meaning that P/E ratios are negatively correlated with the 10-year yield • Investors should keep a close eye on interest rates • A bearish view on bonds means a bullish view on equities • Historical P/E ratios, at least for the market, are irrelevant!