The U.S. stock market has been volatile and difficult to predict over the past few years.  In 1998 and 1999, the major averages experienced sharp gains.  But, these gains were misleading because the major indices are weighted by market capitalization and the 100 largest market cap companies had parabolic gains causing a disproportionate increase in these indices.  In reality, more stocks declined than advanced.  The market had a bizarre disparity with narrow leadership and the biggest negative breadth divergence in its history that camouflaged the market’s real weakness.  In 2000, the major averages declined, but more stocks advanced than declined on the NYSE.

We believe that these trends were primarily caused by an unusual development of events that impacted the worldwide flow of funds.  The severe financial upheavals in Asia, Russia and South America in 1997- 98 produced a “flight to safety” with emphasis on liquidity and risk avoidance.  This produced a substantial flow of funds into the U.S. capital markets with emphasis on index funds and large capitalization companies that caused meaningful gains in our market cap weighted indices.  However, these trends began to reverse after the NASDAQ 100 traded at 120x earnings and the “internet bubble” reached tulipmania proportions last March.  The internet “mania” caused significant damage with 200 internet companies down over 90% from their highs and 30 of those companies had market capitalizations over $1 billion.  Fortunes were lost and the shake out has  just begun with bankruptcies, layoffs and mergers announced regularly.  These trends are producing a move towards investing in quality growth companies with strong fundamentals, financial strength and realistic valuations.

We continue to be bullish on America!  But, we recently began an economic slowdown after a decade of economic growth and increases in real GDP of +4.2% in 1999 and +5.0% in 2000 – the fastest pace since 1984!  Today, the key question is whether we will experience a soft, rough or hard landing or a recession – two consecutive quarterly declines in real GDP.  We believe that we are experiencing a “rough landing” that will produce an increase in real GDP between +2 – 2.5% this year followed by approximately +3.5% in 2002.  But, we may experience a “profits recession.”  After increasing +14% last year, corporate profits after taxes are decelerating and may be flat in 2001 with a meaningful rebound in 2002.  This year, growth in capital spending (15% of real GDP) will decline to around +4% - the weakest since 1991 - because of lower profit margins and reduced cash flow.  In addition, excess inventories should be worked off by mid year since “just in time” inventory practices have moderated the global inventory and business cycles.  But, the industrial sector is weak with manufacturing production declining –1.1% in December – the largest decline since March 91 – and the capacity utilization rate at 79.1% - the lowest level since March 92.  The Purchasing Managers Index (NAPM) is also at a 10 year low.  Overall, the Fed’s aggressive stance on interest rate reductions combined with an expected retroactive tax reduction package should stabilize our economy as confidence and psychology improve.  However, a recession has occurred in the first half of every Republican Administration since World War II!

Today, the question is why have we experienced a dramatic economic slowdown.  The answer is a Fed induced slowdown with six interest rate increases to reduce our hyper growth combined with an unusual combination of factors.  For example, we recently experienced the following: rising energy prices that reduced GDP by 1%, declining liquidity, a credit crunch as cautious bankers reduced loans, consumer debt to personal income at an all time high, the internet bubble burst, the stock market decline since March reduced stock values by $3 trillion negatively impacting consumer spending by $80 billion, our complicated Presidential election, rising inventories and declining business and consumer confidence – now at a five year low.

Looking ahead, we believe that fiscal and monetary policy will focus on stimulating both capital expenditures and consumer spending and that we will gradually experience a soft take off.  The sky is not falling and the U.S. economy is impressive with its breadth, depth, resilience and entrepreneurial spirit.  Our economy will gradually recover, but growth in the future will be slower than the “hyper growth” of recent years.  This will be positive for inflation and interest rates enabling fiscal and monetary policy to more effectively plan, direct and control the growth of our economy.  A key economic risk is whether cap ex and consumer demand are saturated by the spending boom of recent years and the focus on rebuilding liquidity causes our economic “hangover” to last longer than expected.  Power generation is also a future risk highlighted by the power crisis in California – the largest economy in the U.S. and the seventh largest economy in the world!  Growth needs power and it is time for a  realistic plan of growth for this sector by business, environmental and regulatory groups.  Also, since the U.S. has been the world’s economic engine – 30% of world GDP - over the past decade, we may need coordinated interest rate cuts by the world’s central banks because of the slowdown underway around the world.  Another major concern is Japan’s economic weakness combined with deflationary pressures, high corporate debt levels and record bankruptcies.  Argentina, Brazil, Korea and Turkey are also potential trouble spots.

On January 1, 1999 the euro became the common currency of 11 European countries with 350 million people and a GDP equal to 80% of the U.S. – the world’s second largest economy.  Its first two years of life were difficult with a decline of 30% versus the dollar from $1.17 to $.82.  What went wrong?  The biggest problem was a lack of leadership causing confusion and disappointment combined with cyclical, economic, political and structural problems.  Central bankers and the European Community Bank’s (ECB) President sent changing and conflicting messages.  Politicians have not made much progress against the high unemployment rate (11%), inflexible labor markets, heavy tax burdens and large government debt structures.  In addition, the U.S. economy grew 100% greater than Europe’s economy and $200 billion left the European capital markets – mostly for the magnetic U.S. stock market.  The rise in oil prices will also  have a more negative impact on Europe’s economies.  In addition, Denmark’s rejection of the euro on September 28 will further delay a decision by Britain and Sweden to join the euro block.  Investors are questioning whether Europe has the political will for structural reform.  Also, Greece, wants to join the euro, but its high debt level will weaken the euro’s underlying financial strength.

The weak euro has helped our inflation while negatively impacting the profits of U.S. companies selling and manufacturing in Europe.  Cheaper European products intensified domestic price pressures while profits were negatively impacted for U.S. companies that compete against European companies in the U.S. and Europe because of pricing pressures and unfavorable currency translation.  These trends are beginning to reverse with the euro increasing 14% to $.94 as our economy weakens and Europe continues to grow.  The United States of Europe (USE) is not the USA, but the euro will eventually be a strong dollar competitor and appears to be in a bottoming phase over the intermediate term.  The euro created a unified capital market that has improved growth, increased competition and produced a wave of restructuring, mergers and acquisitions.  The recent German tax cut reforms are also a positive step, but the ECB’s seven interest rate hikes and higher energy costs are causing a slowdown in Europe’s largest economy.  The euro currency is scheduled to begin circulation on January 1, 2002 and it is important to continue structural reforms and build credibility.  This will be a major challenge!  Longer term, the euro will be bullish for Europe.  Today, however, the markets do not believe that 11 countries can act as one.

Inflation is still not a problem, but 2000 ended the nine year run of inflation under 3% with an increase of +3.4% in the Consumer Price Index (CPI).  But, this was primarily caused by the sharp rise in energy prices.  The core CPI (excluding energy and food) rose +2.6% after increasing +2.1% in 1999.  This was caused by the sharp jump in energy prices and above average tobacco price increases to pay for legal settlement costs.  However, the economic slowdown combined with lower energy prices should produce a CPI of around +2.5% this year with core inflation approaching the 2% level again.  The employment cost index (ECI) – benefits and wages – is in line with expectations with quarterly gains slowing after a sharp jump in the March quarter.  For example, the ECI increased +0.8% in the fourth quarter and +4.1% in 2000.  Wage growth – the major concern – increased +0.7% in 4Q, +3.8% for the full year and was flat in January.  The economic slowdown combined with the unemployment rate rising from 4% to 4.5% by mid year should reduce upward pressure on the ECI while productivity gains offset increases in unit labor costs.  Also, the world inflation index is declining and the internet is continuing its deflationary impact.  These are powerful forces!  It will be important to watch the monthly and quarterly trends over the intermediate term.  The big risk is deflation as the global economies weaken.

Since late 1999, the Fed and Chairman Greenspan have been worried that our economy was growing at an unsustainable rate and gradually depleting its supply of workers.  This would inevitably put upward pressure on wages, prices and inflation causing rising interest rates and a sharp slowdown in our economic growth.  So, the Fed’s objective was to slow down our economy, “preempt” rising future inflation and maintain stable economic growth.  The Fed began its attack with a ¼% increase in short term interest rates on November 16, 1999.  The ongoing battle produced six rate increases through last June.  The world’s central banks also increased rates 133 times during this period.  However, at the Fed’s December 19 meeting, the Committee said that “risks are weighted mainly toward conditions that may generate economic weakness.”  Then, on January 2, the Fed unexpectedly reduced the federal funds rate (the rate banks charge each other for overnight loans) by 50 basis points to 6% and the discount rate (the rate charged by the Fed on loans to its member banks) by 25 basis points to 5.75% and then again to 5.50% because of a sharp deterioration in our economy and falling consumer confidence.  The federal funds rate and the discount rate were both reduced another 50 basis points on January 31 with additional cuts likely in March, May and June.

The Fed’s message is that our economic slowdown requires a rapid and forceful response  to aggressively stimulate growth and help prevent our economy from experiencing a hard landing or recession.  It has plenty of firepower!  More importantly, the financial strength and surpluses of our economy will help reduce interest rates and the cost of capital in the years ahead.  For example, our economy produced a record $237 billion surplus in the fiscal year ending October 31 after surpluses of $69 billion and $124 billion in 1998 and 1999, respectively----the first time in 40 years that we had three consecutive surpluses.  The budget deficit is now $2.8 trillion versus a peak of $3.5 trillion in March, 1997 and surpluses of $5.6 trillion are projected over the next decade.  After the deficit is paid off, the U.S. Treasury would have to buy corporate bonds and equities – a dangerous trend.  So, the Fed is in favor of reducing taxes to avoid risking the politicization of the private sector financial markets.  This is a powerful force that will positively impact the trend of interest rates and our economy in the future.

We believe that the U.S. is the best growth stock in the world and that the investment environment will be positive over the intermediate term driven by P/E multiple expansion and then earnings growth.  In 2000, the major averages declined, but the market’s underlying strength was positive – the opposite of 1998-99.  For example, while the market capitalization weighted S&P 500 declined –9.1%, the average price increased +10.4% and more than half of the companies increased.  Unfortunately, the largest 100 companies represent 75% of the index and they declined –16.5%.   We are experiencing a stealth bull market with positive 2000 returns in the following sectors:  defense, energy, financials, healthcare, REIT’s, transportation, utilities and the S&P MidCap and Small Cap indices.  The dramatic decline in technology and high multiple stocks camouflaged the stock market’s underlying strength.  But, the market has been highly volatile with 60% of all stocks off 40% from their three year highs.  This is likely to continue with the SEC’s “Fair Disclosure” rules in effect on October 23 which requires the release of material information to all investors simultaneously.   Unfortunately, this has produced less frequent communication, increased uncertainty and more volatility.

Today, the S&P 500 is selling at 24x estimated 2001 earnings of $57.00 per share with a median P/E of 18 times and appears attractive based upon the current level of inflation, interest rates and future projections.  And, since 1921, the market has averaged a +15% increase 12 months after the Fed started reducing rates.  The message is “Don’t fight the Fed!”  The January barometer was also positive and has a 90% accuracy rate in the postwar period.  Also, margin debt declined 28% from its all time high of $278 billion last March to $198 billion at year end.  While it may decline further, this process has made substantial progress in correcting the previous excesses.  This is also the Chinese “Year of the Snake” and the snake is known for its cunning, evil and supernatural power and is considered the great thinker of the Chinese zodiac.  This implies a positive year for determined and thoughtful stock pickers.  We expect the stock market to climb a “wall of worry” in 2001 with modest gains. <

On the technical front, the stock market’s breadth continues to improve.  For example, on the NYSE, stocks hitting new 52 week lows reached the lowest weekly total since April 1996 while breadth ratios have continued to strengthen.  Also, almost 70% of NYSE stocks are above their 200 day moving average indicating that a major advance for most stocks is developing.  The put/call buying ratio in equity options, a contrary opinion indicator, is near its high and usually occurs near market lows.  In our opinion, these factors indicate that this stealth bull market is likely to last two or three years.  However, high multiple large cap and technology stocks are overowned and overvalued and appear to be in a secular downtrend.  While many have rallied from oversold levels, this group is not likely to regain market leadership until valuations become more reasonable and fundamentals improve.

The demand/supply factors are also favorable for stock prices.  There has been a continued net reduction in shares because acquisitions, mergers and stock buybacks have exceeded stock sales.  In addition, buying power has increased with the mutual fund cash ratio at 6.5% - a four year high - and cash at $1.9 trillion while foreign investors continue to favor the U.S. stock market.  Foreigners now own $1.6 trillion or 8.3% of all U.S. securities.  Almost 80% of the world’s savings is invested in our market because of its liquidity, potential and safety – combined with a strong dollar.  The demand for stocks is growing worldwide.  Overall, we believe that the safety net under our economy and equity market is strong.  We are experiencing a developing bull market that will favor small over large, growth over value and companies with reasonable valuations.  In these volatile times, it is most important to have a consistent investment strategy with patience and perseverance and to own quality companies that will stand the test of time.