Prudential: Small Investor Is Back

The brokerage sees upside in Merrill and Morgan Stanley despite recent market weakness.
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Updated from 11:55 a.m. EDT

Recent weakness in stocks hasn't kept Prudential Securities from casting its lot with those calling a retail investor recovery.

On Tuesday, Prudential upgraded

Merrill Lynch

(MER)

and

Morgan Stanley

(MWD)

to buy from hold, citing a faster-than-expected rebound in individual investor activity.

"While we do not expect a return to bubble-period fervor, we believe signs that recovery will happen are numerous," said David Trone, an analyst at Prudential, in a research note. He raised his price target for Merrill to $54 from $47, and increased his price target for Morgan Stanley to $51 from $47. Prudential has had an investment banking relationship with Morgan Stanley in the past.

Merrill closed up 92 cents, or 2%, at $46.64 on Tuesday, while Morgan Stanley rose 49 cents, or 1.1%, to $43.30.

As evidence of a resurgence by small investors, Trone noted that

Charles Schwab

(SCH)

said its retail brokerage activity increased in May. Also, the Investment Company Institute estimates retail equity mutual funds saw $16 billion in net inflows in April, following outflows in nine of the 10 previous months.

According to AMG Data Services, there have been five consecutive weeks of inflows into U.S. registered open-end equity funds through the week of June 18, the first such streak since March 2002. That compares with the bubble era, when AMG recorded a nine-week stretch of inflows between February and April 1998 and a 15-week run from December 1999 through March 2000.

Since March, the

Dow Jones Industrial Average

has gained 16%, the

Nasdaq Composite

has tacked on 21%, and the

S&P 500

has added 17%. Stocks have given back some of those gains this week, as investors have showed apprehension about the market's advance.

"We recognize a sustained rebound in the retail investor confidence and activity is far from assured. Also, with the strong three-month rally in the major indexes, some improvement was naturally going to result," said Trone. "However, in any context, we must concede it has responded much quicker than we had expected ... Those with the money seem to be comfortable boosting their allocation to equities."

Among traders, Michael Driscoll, of Bear Stearns, says the fact that busted energy stocks, such as

Calpine

(CPN)

,

Dynegy

(DYN)

,

Mirant

(MIR)

,

El Paso

(EP)

, and

Williams

(WMB) - Get Report

are all up sharply since March is evidence that the retail investor is back in the market.

"The small investor hasn't been able to say no to single digit stocks," said Driscoll, adding that volume has been high on other beaten-up names, such as

Lucent

(LU)

and

Nortel

(NT)

.

Still, the experts are not yet ready to hail the dawn of a new bull market. "If this were a massive move, we would be churning record volumes. We would really see fireworks and explosive price action," said John Bollinger, president of Bollinger Capital. "There is no sign of that. This looks like a reasonable intermediate-term upswing within the context of a long-term flat market."

As for Trone, he lifted his 2003 earnings estimate for Merrill to $3.00 a share from $2.85 a share, and his 2004 estimate to $3.30 from $3.10 to reflect higher revenue in asset management and retail brokerage. The analyst upped his 2003 EPS estimate for Morgan Stanley to $3.05 a share from $2.95 a share and his 2004 estimate to $3.65 from $3.45, also based on higher revenue from retail investments.

Back in May, Trone downgraded Merrill Lynch to hold because of valuation and margin expansion concerns. "We continue to harbor

margin concerns, but this surprisingly quick improvement in the retail investor activity could help somewhat," he said, adding that the firm would be most favored by improvement in higher-margin investment banking activities, which is not yet apparent.

Separately, the analyst said that the risks related to Morgan Stanley's aircraft leasing activity appear to be dissipating. In the second quarter, Morgan Stanley recorded a $287 million pretax impairment charge for that business. For there to be another charge of that size, conditions in the aircraft leasing market would have to sink below that of the March to May period, which included airline bankruptcies, panic over SARs, war in Iraq, and increased tension over terrorist attacks," said Trone.