This has been a difficult year for stock markets worldwide with a massive wealth meltdown. While the major industrial economies are recovering from last year’s recessionary environment, stock prices declined sharply after a modest gain in the first quarter. This turbulent correction appeared to climax on July 23 when the NYSE recorded 917 new 52 week lows on record volume. Results of the following indexes through July 23 indicate the extensive damage:

This sharp broad based decline was caused by a combination of unusual events not totally justified by the fundamental economic trends. These events included the implosion of Enron and Anderson followed by scandals at Adelphia Communications, Dynegy, Global Crossing, ImClone Systems, Quest Communications, Tyco, WorldCom and Xerox. The $3.8 billion fraud and bankruptcy at WorldCom was the largest in U.S. history. These corporate scandals and earnings problems combined with anxiety from potential terrorist attacks, Middle East fighting, a potential India – Pakistan nuclear conflict, Latin American economic problems and the cost and uncertainties of a war with Iraq created a high level of investor disillusionment, pervasive gloom and selling pressure. This selling pressure produced unusual price declines fueled by margin calls, mutual fund redemptions ($48 billion in June and July - the largest two month total on record) and foreign selling because of the declining dollar and stock prices. There was fear, frustration and panic that produced capitulation selling with large percentage declines on high volume. Wall Street has been under attack! The key questions today focus on the outlook for the economy, profits, stock market valuation levels and investor psychology.

After a recession with three quarterly declines in 2001, the U.S. economy began to recover in 4Q 2001 and then rebounded sharply in the first quarter aided by the warmest winter in over 100 years with an increase in real GDP of +6.1%. The second quarter increased +1.1% because of slower consumer and government spending and a weaker trade deficit and we appear to be in a “soft spot” in the economic recovery. We expect growth of +2% to +3% in the second half and somewhat higher in 2003 fueled by rising consumer spending – aided by a +30% increase in real disposable income - combined with inventory rebuilding and a gradual improvement in capital spending. Inventories are very low with the inventory to sales ratio at 1.35 – the lowest in the 10 year history of the survey. Capital spending – a key ingredient - increased +2.9% in Q2 after seven declining quarters and should gradually strengthen as profits and cash flow grow in the quarters ahead. This is a key ingredient to our economic recovery. The Job Creation & Workers Assistance Act of 2002 will also help capital spending since it improves cash flow by extending the operating loss carryback period from two to five years and allows a 30% bonus on first year depreciation allowance for new investment. The auto and housing industries also experienced good growth. Our economy has been aided by a large cushion of liquidity injected into the banking system, rising wages, increased government spending and the tax reduction package.

Today, however, there is concern that the devastating market decline will produce a “negative wealth effect” causing a consumer spending slowdown and a “double dip” recession. While $8 trillion in equity value has been lost since March, 2000, with 40% of that in June and July, real estate wealth increased $2.7 trillion. This neutralized the stock market decline over the past two years since the housing “wealth effect” is more than twice that of equities. In addition, low mortgage rates are generating a high level of refinancings and extra consumer spending power. But, it is reasonable to expect a near term slowdown in spending because of the market’s recent sharp decline that wiped out 25% of household equity assets combined with high consumer debt levels. Investors are shell-shocked and this hit will be a drag on spending in future months. At this point, the economy is vulnerable to a further sharp decline in the market or other military, political and terrorist shocks. More importantly, the U.S. economy has major support systems. These include a large government workforce, a financially secure retirement community, Social Security, unemployment insurance and government agencies such as the Farm Credit System, Federal Deposit Insurance Corp., Federal Home Loan Bank Board, Federal Savings & Loan Insurance Corp. and, more importantly, the Federal Reserve System. These supports working together provide a solid foundation for our economy and future growth. The U.S. economy continues to be impressive with its breadth, depth, resilience and entrepreneurial spirit.

The U.S. economy recently experienced its worst profits recession since World War II. Since peaking in the third quarter of 2000, S&P 500 earnings fell more than 50% - the greatest percentage decline since the 1930’s, - while total corporate profits declined 25%. Some sectors were worse with earnings in the electronics sector declining from an annual rate of $23 billion in 1997 to $9 billion! Auto industry profits are only 25% of their late 50’s level adjusted for inflation and total manufacturing profits are half of their mid 1997 level. We have experienced a Great Depression in profits that was deeper and more frightening than any other in our lifetime. In view of this trend, what can we expect in the future?

We believe that we may have seen the worst and are likely to experience above average earnings growth over the next few years despite today’s confusion and uncertainty. Corporate America has been undergoing an extensive restructuring that will produce increasing productivity, margins and profits as revenues rise. Productivity growth averaged +2.9% over the past five years and almost +4% since early 2001 despite the recession. This trend is likely to continue with rising sales, moderating wage gains and less deflationary pressures because of the weaker dollar. The dollar’s 10% trade weighted depreciation since February will boost exports and increase profits since 25% of U.S. corporate profits come from overseas. But, future earnings growth will be impacted somewhat by the expensing of options and rising pension fund contributions. Despite the drumbeat of negative news, we are cautiously optimistic about profits in coming quarters. The second quarter is producing the first increase in S&P earnings after six declining quarters - the worst since 1952 - and many of our companies are reporting earnings somewhat better than expected. Near term, the recent corporate financial scandals will rapidly produce more accurate earnings reports and we will shortly have the highest quality accounting and earnings reports in the universe. The U.S. stock market will become the equity gold standard!

Inflation is not a problem and has been under 3% for the past 11 years except for 2000 when it jumped to +3.4% because of the sharp rise in energy and tobacco prices. Today, current projections for the Consumer Price Index (CPI) are for increases of +1.6% this year and +1.8% in 2003. The CPI rose +0.1% in June and +1.1% over the past year – the lowest level in 37 years – while the core CPI (excluding energy and food) rose 0.1% in June and +2.3% over the past 12 months. Inflation has always declined in the first year of an economic recovery, but the good news this time is that the slowdown is broadbased. The global inflation index is also subdued. The intense worldwide competitive pressures are continuing to suppress inflation. The big risk is deflation! With low inflation and modest economic growth, the Federal Reserve will not increase interest rates until the economy strengthens more in 2003. Fed Chairman Greenspan made his semi-annual summary of monetary policy on July 16-17. He said that “with inflation contained, the Fed has chosen to maintain its accommodative policy stance until consumers and businesses are on a solid growth path since the pace of forward momentum remains uncertain.”

We did not expect the speed and depth of the recent stock market decline. There was a two tiered market over the past few years, but the past few months were different. Almost all stocks declined sharply in one of the most vicious sell-offs in memory. We appear to be experiencing the final phase of the boom - bust cycle after investors fed the largest speculative boom in market history in a climate of “infectious greed.” However, we now have “irrational despair” and our top priority must be to attack the “crisis of confidence” and restore the trust of investors. We expect prompt Federal action to restore integrity to corporate governance and financial reporting. Today, it is most important to make a clear and realistic appraisal of the stock market and investment alternatives.

In our opinion, the U.S. stock market today provides the best opportunity for above average returns over the intermediate term and no other asset offers such growth and liquidity. Periods of maximum uncertainty are usually periods of maximum opportunity. While stock prices may go lower, we appear to be in a “bottoming phase” that should emerge on the upside as companies continue to report more favorable earnings comparisons in the quarters ahead. Since 1776, it has been wrong to bet against America and that is also true now. The U.S. market represents 50% of the world’s equity market and our economy is the strongest in the world with a vibrant private sector, flexibility and entrepreneurial spirit. To bet against America today must assume a lengthy worldwide recession with flat to declining earnings. We believe that is a poor bet.

What are the investment alternatives and their projected annual returns? They are as follows: money market funds +1.7%; 10 year U.S. Treasuries +4.3% and 30 year Treasuries +5.2%. The bond market’s low yields now make it mathematically impossible to generate high returns unless we have deflation. Real estate has equaled the inflation rate plus 1% since 1975 - less 2% of market value for annual maintenance costs and taxes. On the other hand, quantitative studies indicate that the long term total return of equities is approximately +11%. In recent years, it was much higher. But, based upon the S&P 500, we have now experienced the longest and worst bear market since World War II with the S&P declining –49% since March 2000. Our market is correcting its recent bubble similar to the bubbles of 1929, 1968-72, 1987 and 1989 in Japan.

From a valuation standpoint, the S&P 500 appears attractively priced selling at 19x and 16x estimated 2002 and 2003 earnings per share of $44 and $53, respectively. While the historical average is 15x, current multiples are attractive based upon the current level of inflation, interest rates, yields and projected growth. As a result, stock market models indicate that the market is undervalued by 15% to 35%. We are also entering the third Presidential year which is historically the best for stock prices with an average gain of +14% since 1929. The market’s four-year cycle low is also positive with substantial gains likely for the next two-year period. The probabilities and fundamentals strongly favor a positive market environment. The demand/supply balance is also favorable with a net reduction in shares because of acquisitions, mergers and accelerating stock buybacks. Buying power is also increasing because of the rapidly rising cash position combined with increasing annual pension funding and 401K contributions. There is enough firepower for a major recovery in stock prices over the next two years. While stock market declines are frightening, they are a fact of life. It is critical to have a long term view and a consistent diversified investment strategy with patience and perseverance. In our opinion, the USA is the best growth stock in the world and quality smaller growth companies are the most attractive segment of the market today. It is time to be positive!