American Capital Management, Inc.

ECONOMIC & INVESTMENT SUMMARY
FEBRUARY, 2003

The past year was most difficult for equity investors and all the major indices declined. It was the worst year for equities since 1974 and the fifth worst over the past 77 years with sharp declines in July and October. Bonds and cash outperformed the major equity indices for the third consecutive year. Over the past 100 years, that only happened twice – in 1929-1932 and 1939-1944. Last year’s dismal results are summarized below:
 
Dow Jones Industrials -15% NASDAQ Telecommunications  -54% 
Dow Jones Total Market  -23% NYSE Composite -20%
Dow Jones Utilities -27% Small Cap Growth Funds -30%
MidCap Growth Funds -28% S&P 500 -22%
NASDAQ BioTech -45% Value Line -29%
NASDAQ Composite -32% Wilshire 5000 -22%

In our August summary, we mentioned that the decline through July was caused by a combination of unusual events not totally justified by the fundamental economic trends. That was also true for the full year with fear, frustration and panic causing heavy selling pressure. These events included U.S. corporate bankruptcies, fraud and scandals, Middle East fighting, potential war with Iraq, N. Korea nuclear problem, the Pakistan – India nuclear war risk and the crisis in Venezuela combined with the anxiety of potential terrorist attacks. Today, it is important to carefully analyze the outlook for the economy, profits and inflation and their impact on the stock market.

THE ECONOMY

The U.S. economy increased 2.4% in real GDP last year and 0.7% in the fourth quarter. The last quarter was the weakest since the third quarter of 2001 when we were in recession. At present, our sluggish economy is in a “soft spot” with a number of crosscurrents, but the index of leading indicators rose every month in the fourth quarter and the manufacturing index expanded for the third consecutive month in January. We expect a broadening of demand to gradually develop with an increase in real GDP of 2.5% this year. The Bush Administration’s aggressive tax reduction fiscal – stimulus plan will be passed in modified form by Congress this spring to further support our economy. The U.S. will continue to be the world’s growth engine until we have a more balanced global recovery. Growth this year will be led by increasing Federal spending, continued consumer demand, a mixed recovery in business spending and a stable housing market with home ownership at a record 68%. Federal government spending – led by defense – will increase around 8% to continue to be the fastest growing area of our economy. This will produce a federal budget deficit of $300 billion – 2.8% of GDP – versus $175 billion in calendar 2002. In addition, the Federal Reserve has maintained an expansionary monetary policy and left interest rates unchanged at its January 28-29 meeting. The Fed believes that rising oil prices and geopolitical risks - the “wild cards” - have temporarily restrained the economy and that its stimulative policies should provide economic support as these risks moderate. Consumer spending will continue to support our economic growth this year despite consumer confidence at a nine year low. The main catalyst will be rising personal income growth of around 3.5% generated by employment growth and wage gains. In addition, low mortgage rates produced record refinancing activity around $170 billion and lower debt servicing costs. The consumer is in decent shape because household debt as a % of total assets declined 17% since 1995 - its lowest level since the late 1980’s – and the debt burden – loan payments as a % of income – has been declining because of lower interest rates and rising incomes. Finally, we expect the cavalry - business spending – to arrive and gradually improve after a sharp decline in 2001 and stabilizing in 2002. The fundamentals for a capital spending recovery are gradually falling into place since profits and cash flow are improving, equipment is aging and government tax policies are encouraging investment. In addition, inventories are low and we expect moderate inventory accumulation this year. Uncertainty is the enemy of growth and the threat of war with Iraq and North Korea are drags on our economy. We expect these issues to clarify over the intermediate term followed by a more favorable economic and investment environment and greater flexibility in worldwide economic policies. This year is likely to be a transition period as our economy works off the excesses of the 1990’s and corporations and individuals focus on improving their financial strength.

CORPORATE PROFITS

The U.S. economy experienced a severe profits recession during the 1½ year period ending March 2002. Since then, we have had three consecutive quarters of rising profits and economists are projecting a +10% increase this year. The key factors supporting this improvement are broadening economic growth, modestly improving pricing and continued productivity gains. The recent dollar weakness will also help our exports and U.S. multinational profits – 25% of total corporate profits. Later this year and next, we expect our exports to strengthen as the major foreign economies benefit from our continued growth – 25% of world GDP – and more stimulative government policies. This should help produce another double digit increase in corporate profits in 2004. Overall, earnings and cash flow should rise faster than revenues because of the extensive restructuring and streamlining implemented by most companies.

INFLATION & INTEREST RATES

Inflation increased 1.6% last year and has been under 3% for 11 of the past 12 years. In addition, core prices – excluding energy and food – increased 1.9%, the slowest rate since 1965. In addition, the core producer price index declined 0.3% in December for the fourth decline in six months -- the first time in its history. Today, deflation is the new enemy with sluggish worldwide growth and intense competitive pricing pressures. As a result, the Fed has assumed a deflation fighting posture by flooding the economy with money, keeping interest rates low and allowing the dollar to weaken. As a result, we expect prices to firm somewhat during the year with the CPI increasing around 2%. The Fed may increase rates slightly as the economy strengthens later this year and bond prices may decline as the current 10 year Treasury note yield of 3.93% rises somewhat.

INVESTMENT OUTLOOK

We believe that the U.S. stock market provides the best opportunity for above average returns over the intermediate term – despite the economic and geopolitical challenges. We recognize the risks, but expect positive action to improve investor psychology and release the entrepreneurial spirit, fundamental strength and resilience of our economy. A favorable stock market environment is important to our economic health and government policies will encourage equity investing. In addition, Bill Donaldson, the proposed new SEC Chairman, is well respected and will improve our “corporate credibility crisis” and investor confidence. We are “cautiously optimistic” and believe that there is too much bearishness, gloom and pessimism. For example, last year, investors withdrew $27.1 billion - 0.9% of assets – from stock mutual funds for the first time since 1988. Fundamentally, the S&P 500 is selling at 17x estimated 2003 operating earnings of $50 per share – an attractive level based upon the current level of inflation, interests rates and projected growth. We continue to believe that the USA will prove to be the best growth stock in the world in the years ahead and that quality smaller growth companies are the most attractive segment of our market today. Also, 2003 is the “Year of the Black Ram” in the Chinese calendar and is considered a turning point year. Rams are gentle, peaceful and surefooted and usually fight to end conflict. These are positive signs. In conclusion, we offer the following observations for your consideration:
    THE PROBABILITIES FAVOR HIGHER STOCK PRICES
    OVER THE NEXT TWO YEARS
  1. Bear Market – the S&P 500 concluded its third consecutive annual decline in 2002 and its longest cyclical bear market in 60 years. We are overdue for a good year!
  2. Technical Position – many professional technicians believe that the market has been forming a “bottoming process” and a probable “double bottom” from July-October and that we are likely to experience a cyclical bull market over the next two years.
  3. October Market Bottoms – The stock market bottomed in October in each of its 10 major recorded bottoms since 1962.
  4. Cash Positions – there is plenty of cash available to fuel a meaningful rise in stock prices. At the market’s bottom in October, it was estimated that dollars in money market and intermediate term bond funds equaled 70% of the total market value of all listed stocks.
  5. Fundamentals – the stock market appears undervalued based upon most historical quantitative valuation measures. The most important ingredient is earnings and we just experienced three consecutive quarterly increases in corporate earnings after six declining quarters. And, professional economists are projecting double digit profit gains this year and next.
  6. Recoveries After Bear Market – since 1949, the average recovery 12 months after a market low was +37% with the lowest being +21% after December 87 and the highest +58% after August 82.
  7. Presidential High/Low – Since 1934, the S&P 500 has produced an average annual gain of +51% from its low in the second year after a Presidential election to its high in the year before the next election.
  8. Third Presidential Year – has experienced rising stock prices every year since 1940 with an average gain of +14% since 1929 and +17% since 1950.
  9. Third Presidential Year With War – produced an average S&P 500 gain of +18% since 1946 with a low of +11% in 1971 and a high of +26% in 1991. The wars and years were the Korean War (1951), Vietnam War (1967 & 1971) and the Gulf War (1991).
  10. Hemline Indicator – the stock market increases the majority of those years when hemlines are rising. This year’s fashion is rising hemlines!
  11. Super Bowl Indicator – the stock market rises 80% of the time in those years when an NFC team wins. Tampa Bay won this year – an NFC team.
  12. Short Interest – is at an all time high as a percentage of total NYSE shares outstanding. This represents significant buying power.
  13. Election Year Results – Since WWII, the stock market has increased in Presidential election years 85% of the time and 76% of the time since 1932.
  14. Timing the Market – from 12/31/69 – 6/30/02 the compounded annual return of the S&P 500 was +7.6%. But it was only +4.6% if you missed the 20 best days and you lost money if you missed the best 90 days – over 32 years! It is impossible to predict strong stock market rallies and those heavy in cash and bonds miss the move and can not catch up. It is riskier to miss market strength than to experience market declines.
  15. Investment Success – the key to building wealth is to steer a steady course with a consistent investment strategy. Investors need patience and perseverance and to own quality growing companies that will stand the test of time.