This has been a difficult and volatile year in the stock market.  The major averages increased in the first half and then declined in the third quarter.  But, many investors are not doing as well because the majority of stocks are not performing – just like 1998!  The performance of the DJIA, NASDAQ and S&P 500 has been misleading.

In 1999, the stock market has experienced a continuation of last year’s narrow market leadership.  For the nine month period ending September 30, the +5.36% gain in the S&P 500 can be attributed to only 11 large cap stocks.  Actually, the average stock declined during this period and by mid October, the average NYSE stock was 30% below its 52 week high.  Also, for the week ending October 15, the DJIA declined 630 points or 5.9% for the worst weekly percentage performance in a decade.  Finally, the NASDAQ index of 4,845 stocks has doubled over the past year, but only 65 stocks account for this gain and only five stocks – Cisco Systems, Intel, MCI WorldCom, Microsoft and Sun Microsystems - represent half the gain.  Actually, the median decline on the NASDAQ and NYSE from April, 1998 is –7.1% and –17.5%, respectively. We have been in a “stealth” bear market since the spring of 1998 caused by an increasing emphasis on index funds and large capitalization companies.  This emphasis is the result of an unusual combination of demand and supply factors impacting our stock market.  In addition, this emphasis has caused declining liquidity in the remainder of the market and unusually wide price swings.  The  “Nifty 50” high multiple large capitalization companies are overpriced – it is time to de-emphasize these issues.

We are bullish on America!  The major surprise in 1999 has been the continued strength of our economy with an improving level of corporate profits.  The “New Economy” is impressive and it has been a mistake to underestimate its breadth, depth and resilience.  In the future, our economy is likely to continue to provide favorable surprises.  In the third quarter, real GDP increased +4.8% and the full year number is likely to be over +4% - stronger than last year’s +3.9%.  Next year, growth of at least +3.5% appears reasonable in the tenth year of our economic expansion.  This year, corporate profits after taxes should increase over 10% after declining –2.2% in 1998 and are projected to increase over 6% next year.  This strength has been fueled by strong gains in consumer spending, housing and business investment.  Consumer spending has been remarkably strong with gains exceeding income growth because of a combination of the “wealth effect” of both housing and stock market gains, the high level of consumer confidence and the enthusiasm for credit.  But, the quarterly progression of consumer spending is slowing from +6.5% (Q1) to +5.1% (Q2) to +4.3% in (Q3).  The housing market has also been strong with a high level of sales, but housing starts have declined since last January.  Business investment continues to increase at double digit levels because of strong cash flow and the large amount of capital being raised in the IPO market – especially among the internet group.  Finally, our exports should continue to increase because of the strengthening economies in Asia, Europe and Latin America.  Overall, these trends support continued growth in our economy, but at a somewhat slower rate in the quarters ahead.  Our economy is still likely to grow faster than the European economies while their stock markets are at similar levels.  The unprecedented performance of the U.S. economy reflects an innovative and technological “revolution” that has led to an accelerating improvement in productivity.  Buy America – the best quality growth stock in the world!

The Year 2000 (Y2K) or millennium bug has received increasing worldwide attention over the last two years.  The problem is simply that computer chips programmed with old codes will mistake the year 2000 for 1900 and crash causing serious operational disruptions and a major economic slowdown.  The second problem is public fear and the impact of behavioral expectation and action.

After analyzing this issue, we believe that the Y2K bug is likely to cause some international economic disruption with a modest slowing effect on our economic growth next year.  In the U.S., it is estimated that almost $100 billion has been spent to fix this problem and Y2K compliance has escalated quickly.  Most of our major industries and infrastructure have already been satisfactorily tested.  Also, April 1 was the beginning of fiscal year 2000 for Canada, Japan and New York State and there were no major disruptions.  In addition, the recent euro-conversion was technologically more complicated than Y2K compliance and it went smoothly.  In the near term, it is logical to expect some economic crosscurrents because of the public’s perception and concern.  For example, a recent Gallop Poll found that 22% of adults expect the banking system to shut down.  Thus, the Fed is printing an extra $50 billion in cash to meet any unusual withdrawal demands.  Clearly, the banking industry has failed to communicate a sense of security to its depositors.  Also, some companies ordered extra inventory of key parts as a hedge against worldwide manufacturing problems and shortages.  This has created some artificial growth in the second half of this year that will moderate somewhat in the first half of 2000.  More serious disruptions in under-developed countries may also produce a temporary drag on world trade next year.  On balance, the system will work and those isolated production problems that develop in early 2000 will receive priority for corrective action.  This problem may end up being the “millennium shrug.”

Y2K has also produced some positive developments.  First, the global coordination that Y2K required has produced a more efficient worldwide communications network.  This will help growth in the years ahead.  Secondly, the Y2K fix will free up funds that will be redirected to more productive spending on information technology like electronic commerce that will yield higher returns.  In summary, the Y2K problem has strengthened the world’s telecommunications infrastructure and will help facilitate worldwide economic growth in the years ahead.  Y2K concerns may also promote a “flight to safety”  that will increase the demand for dollars and U.S. Treasuries.

The Fed’s target is to control inflation to prevent an excessive rise in interest rates and to maintain stable economic growth without causing a significant sell-off in the stock market.  In the past, the economy drove the stock market, but now the opposite is true and the market has become a key component in the Fed’s thinking.  The key concern is that the “wealth effect” of rising stock and home prices will generate more consumer spending and demand in excess of the nation’s supply of labor, materials and services causing inflation.  The Fed is worried that the tight labor market will cause rising wages and inflation despite a capacity utilization rate of only 80%.  Thus, we can expect the Fed to “target” the stock market as long as our economy continues to grow faster than its potential.  As a result, the Fed increased short term interest rates ¼% on November 16 with the federal funds rate at 5.5% and the discount rate at 5%.  If stock prices continue to rise sharply, we may also see a rise in margin requirements.  This would have a sobering effect since margin debt is $173 billion - an all time high and is at its highest percentage of GDP.

The next key factor in the Fed’s thinking is the strengthing of our economy in 2000 – an election year.  Clearly, the Fed does not want to be in a position where it has to steadily increase rates causing a market correction and economic decline.  This could then have an influencing impact on the Presidential election.  It appears that the Fed’s secret game plan is to take the “speculative fever” out of the stock market and slow the rate of economic growth by trying to talk down the stock market.  Mr. Greenspan has been reminding investors that expected earnings growth appears high and risk premiums may be too low.  Then, if the economy slows too much next year because of Y2K or other factors, the Fed could reduce rates to help keep our economy stable during an election year.  Rising government surpluses will also reduce borrowing needs and ease pressure on the bond market.

Have no fear – inflation isn’t here!  Not yet anyway.  But, we are experiencing a gradual updrift from the cyclical low in our CPI of +1.6% in 1998 to +2.1% this year with projections of around +2.3% in 2000.  The key point is that 1999 will be the ninth year in a row of inflation under 3%.  Inflation is not about to explode.  The “New Economy” of accelerating technological innovation is creating a “New Era of Wealth,” with steady growth, improving productivity and relatively low inflation.  While the CPI increased +0.4% in September, the core CPI – excluding food and energy – rose +0.3% and only +2.0% year to year.  Excluding tobacco, the core rate was only +1.6% over the past 12 months - a 33 year low!  Also, the core rate of the Producer Price Index has only increased +0.9% over the past 10 months versus +2.5% last year.  It is important to note that energy prices have increased sharply primarily because of OPEC production cutbacks.  And, tobacco prices increased +32% over the past year because cigarette
companies raised prices to pay lawsuit settlements.  Recently, the unemployment rate declined to 4.1% - a 30 year low, but hourly wages increased only +0.1% and are now up +3.6% over the past year.  The employment cost index – wages and benefits – is only +3.1% higher than a year ago.  These figures indicate that there is no current evidence of labor cost pressure.  Also, on October 28, the Bureau of Economic Analysis released its comprehensive revision of historical data which highlighted the acceleration of productivity in the 1990’s.  For example, the productivity growth rate was increased from +1.9% to 2.6% annually over the past three years primarily because of the reclassification of software purchases as an investment rather than as an expense.  Unit labor costs have risen more slowly in the 1990’s than any cycle on record!!  Internationally, the world CPI is projected to decline 22% to +2.9% next year with declines in Eastern Europe and Latin America.  The G7 countries are expected to increase slightly from +1.2% to +1.3%, but there is no evidence that inflation is a problem.  Global inflation is at a 40 year low!  And, while some are worried about the recent strength in industrial commodity prices, this appears to be a rebound from the depressed levels caused by the Asian financial crisis.  There has not been any direct historical relationship between commodity prices and inflation since the mid 80’s.  Finally, the internet is deflationary for the world.

So, what is the Fed worried about?  The Fed is worried that the U.S. is depleting its available supply of workers that will eventually cause an acceleration in wages and inflation.  But, recent wage gains have been offset by the continued improvement in productivity and access to low cost foreign labor is keeping a lid on wage pressures.  Plus, workers are not demanding bigger wage increases because of low price inflation.  Workers are more interested in profit sharing incentive plans and capital gains with stock grants and options.  Looking ahead, we are more worried about deflationary pressures the next time we experience a modest recession.  Actually, prices for consumer goods other than energy, food and tobacco declined during the past year.  Powerful global anti-inflationary forces are alive and well with deflation in Argentina, China, Japan and Hong Kong.

We believe that the investment outlook is favorable for the majority of stocks over the intermediate term.  In general, the stock market appears fully priced with the S&P 500 selling at 27x and 25x estimated operating earnings per share of $51 and $56 in 1999 and 2000, respectively.  But, if the 50 highest multiple issues are excluded, the S&P 450 is selling at 22x this year’s earnings and appears attractive based upon the current level of inflation and interest rates.  The market’s overpriced sectors include the highest multiple large cap stocks and the internet group.  For example, the 241 Internet IPO’s now have a combined market value of $549 billion with sales of only $24 billion and a combined loss of $7 billion!!

The demand/supply picture for stocks continues to be favorable.  Demand is supported by a combination of rising individual, retirement and pension investing, foreign purchases and corporate buybacks.  Supply has been reduced 1% annually over the past five years because new stock offerings have been exceeded by stock buybacks, mergers and acquisitions. This reduction in supply is causing increasing volatility in the overall market.  So, buckle up and be prepared for more turbulence on the road ahead.  Stock market declines are always frightening, but they are a fact of life for investors.  But, don’t forget, if you missed the best 40 days in the stock market over the past 20 years, your compounded annual return would have been reduced by over 60%.  It is riskier to miss market strength than to experience market declines.  The key is to have patience, maintain a consistent investment strategy and own quality companies that will stand the test of time.  Looking ahead, 2000 is a Presidential election year which is historically positive for stock prices.

Today, we strongly believe that quality small and medium sized growth companies are attractive and will outperform the market in the years ahead.  This market segment has continued to underperform despite above average revenue and earnings growth.  As a result, this sector is historically attractive based upon relative price earnings multiples and projected growth rates.  Some publicly traded companies offer better value than privately owned businesses.  The majority of stocks have been in a bear market for 1½ years with deteriorating breadth, momentum and sentiment.  We expect this trend to gradually change in the quarters ahead as small cap and value stocks receive increasing attention from strategists and investors.  Since mid October, stock prices have strengthened and the technical position of the bond and stock markets has improved as we enter the seasonally strong November – January period.  Our market segment should gradually develop a more favorable technical position over the intermediate term with improving relative strength.