In our summary last February, we mentioned that 2002 was the worst year for equities since 1974 and summarized the market’s dismal results. Our investment outlook was that the U.S. stock market provided the best opportunity for above average returns and we listed 15 reasons why the probabilities favored higher stock prices over the next two years. Today, we believe it timely to summarize below this year’s favorable results through September 30.
 

Dow Jones Industrials	+11%	NASDAQ Telecommunications	+35%
Dow Jones Total Market	+15%	NYSE Composite	+13%
Dow Jones Utilities	+16%	S&P 500	13%
Dow Jones World Index	+20%	Value Line	+21%
NASDAQ BioTech	+45%	Wilshire 5000	+16%
NASDAQ Composite	+34%

What a difference a year makes! The underlying strength of the stock market has been surprising. International stock markets were also strong with Asia and South America generating impressive results. Looking ahead, we expect 2003 to end favorably and that we are likely to experience higher prices in 2004. But, next year will be more challenging!

The National Bureau of Economic Research declared that the last U.S. recession ended in November, 2001. In 2002, real GDP increased 2.4% with projections of +2.7% this year and +4.0% in 2004. Our economy has been expanding for almost two years, but only now are the basic cyclical forces falling into place for a sustainable expansion over the next few years. The fundamental underlying strengths of our economy have overcome the depressing economic effects of the cold winter, corporate scandals, Iraq War, higher energy prices, wet spring and SARS. Our economy is benefiting from a powerful combination of fiscal and monetary policy designed to accelerate our growth. Today, the key drivers are government and consumer spending combined with a strong housing market and mortgage refinancings because of low interest rates. Tomorrow, we expect our economic growth to broaden from the impact of increasing business spending, inventory rebuilding, job growth and rising exports. The monthly inventory to sales ratio is at its lowest level on record – so inventory accumulation should be positive through next year while the weaker dollar makes our products more price competitive and should increase our exports and attract tourism. Also, job growth began with a payroll gain of 57,000 in September and temporary employment increased for the fifth straight month. Commodity spot prices have also been firming which suggests that global industrial activity may be recovering faster than expected. The U.S. economic expansion combined with improving foreign economic growth is likely to produce sustained world growth over the next few years. But, there are economic, geopolitical, military and terrorist risks that could impact this outlook.

The U.S. economy experienced a severe profits recession during the 1½ year period ending After peaking in the third quarter of 2000, the U.S. economy experienced its worst profits recession since World War II. However, since the first quarter of 2002, Corporate America has experienced six quarters of rising profits and after tax corporate profits should experience double digit gains this year and next. Also, corporate cash flow is at record highs and is rising faster than earnings because of aggressive cost streamlining and the increase in first year depreciation allowances from 30% to 50% for business investments made after May 5, 2003. This will help corporations increase spending, raise dividends and strengthen their balance sheets. Also, the recent dollar weakness will help exports since our products cost less on world markets and 25% of total profits are derived from international sales. Corporate America is on the move!

It appears that the U.S. economy may be at the beginning of a major technological revolution with above average productivity gains – output per working hour. Productivity growth was less than +1.5% per year in the 70’s and 80’s, +2.5% from 1995 – 2000, +3.4% since 2000 and +5% today. This significant productivity improvement was caused by a series of developments such as advances in biotech, cellular, fiber optics and wireless technologies, explosive internet growth and rapid progress in computer capabilities combined with intense worldwide competition that created a focus on efficiency. We are experiencing a boom in technology innovation and productivity which will improve growth in corporate profits. On the negative side, it will suppress the level of job growth since companies are able to increase their output without hiring as many new workers. Eventually, strong productivity growth will lead to more jobs as higher wages stimulate consumption and higher profits induce more business investment. Corporate America is on the move!

The world’s economies are at a crossroads with major implications for the future. The key question is the future direction of prices in the years ahead. The world has been in a disinflation mode for years and deflationary forces – the enemy – are spreading through Asia, threatening America and Europe. In the U.S., inflation increased +1.6% last year and has been under 3% for 11 of the past 12 years. This year, for the 12 months ended September, the CPI rose +2.3% compared with +2.4% in 2002. More importantly, core prices, excluding energy and food costs, increased only +1.2% - the smallest increase since 1966 – and down from an increase of +1.9% in 2002. The U.S. economy is dangerously close to a deflationary environment. The problem is debt repayment with dollars that have less purchasing power if we had deflation. This would put pressure on profit margins, impede the revival of business spending, cause rising bankruptcies and slower or no growth in the U.S. and abroad. Also, stock prices would probably decline with unfavorable business and consumer psychology and a negative “wealth effect.” The Federal Reserve believes that the probability of disinflation exceeds that of a rise in inflation from current levels – a landmark in Fed history! The Committee believes that this risk remains the predominant concern since weak business pricing power will impede our recovery and limit job growth until this disinflation dynamic is reversed. As a result, the Fed left the federal funds rate unchanged at 1% in September and believes that an accommodative monetary policy and stable rates can be maintained for some time. In our opinion, the combination of stimulative fiscal and monetary policy will gradually produce more favorable economic growth and the dollar’s decline will help ease pricing pressures in the U.S by raising the prices of imports. We expect the forces of reflation to overcome the forces of disinflation. Next year, the increase in the CPI should decline somewhat because of projected lower energy prices while “core” inflation should begin to strengthen. This outlook should enable the Fed to keep interest rates low, but higher rates are likely as our economy strengthens. In addition, the U.S. reported a budget deficit of $374 billion for the fiscal year ending September (3.5% of GDP – the highest since WW II was 6% in 1983) with projections of $500 billion next year. Eventually, this will be a problem requiring reduced spending and more taxes if our expanding economy does not generate enough tax revenues.

China bashing is popular today with politicians blaming it for the jobless recovery, creating a dangerous shift toward protectionism. In reality, U.S. manufacturing employment has been declining since 1979 while China benefited from the struggle for survival by high cost western producers. Today, the U.S. and China are the world’s two growth engines with a mutually beneficial economic synergy. U.S. consumers and corporations benefit from low cost imports while China is our fastest growing export market. For example, General Motors recently sold more cars in China than Japan. China has also become our supply chain after 15 years of accelerating U.S. investing – despite international currency swings. Today, 10 of the top 40 exporters from China are American companies like Dell and Motorola. Wal-Mart accounts for 10% of China’s exports providing low cost products to American consumers. Without China, many U.S. companies would be less profitable and pay lower wages. In addition, China is a major buyer of U.S. Treasuries helping to finance our deficit and keep interest rates low. On the negative side, China’s banking system is in terrible shape with non-performing loans estimated as high as 45% and its four largest banks holding China’s total savings of $3 trillion. A major revaluation of the yuan would increase volatility and may bankrupt many banks causing economic disruptions worldwide. But, the yuan - pegged to the dollar since 1994 - and Chinese goods get cheaper when the dollar declines attracting more foreign investment. This is an unacceptable unfair advantage for the world’s economies because of the weak global economic environment. The Dubai G-7 Communique last month calling for “more flexibility in exchange rates” was the first shot across the bow. Eventually, China will probably set a trading range for the yuan and begin major reform of its banking industry. This is a complex issue with positives, negatives and risk that needs to be watched closely.

The stock market has been stronger than expected this year and investor psychology is improving – a refreshing change! There was too much pessimism as many investors overlooked the fundamental strengths and resiliency of our economy. Last February, we listed 15 reasons why the probabilities favored higher stock prices this year and next. Today, we continue to believe that the outlook for stock prices is favorable and that a cyclical bull market is still in force. Growth in productivity, profits and cash flow is strong and S&P 500 operating earnings per share are currently estimated at $53.50 and $59 this year and next - and may go higher. The S&P 500 is now selling at 17.4x next year’s estimated earnings - below valuation models based upon the current level of inflation, interest rates, and profit growth. In addition, the recent Tax Relief Act reduced the tax rate on dividend income to 15% through 2008 and the LT capital gains tax to 15% from 20%. These favorable tax reductions are raising the underlying value of equities. The demand/supply situation continues to strengthen as the net supply of shares declines because buybacks and takeovers exceed offerings, with substantial cash reserves in short and intermediate term bond funds with low yields. Additional buying power will also be generated by 401K contributions and pension funds that are underfunded by over $300 billion. There is plenty of firepower to support the market and provide positive returns. In addition, the corporate scandals of recent years produced high governance standards and we now have the most accurate accounting reporting of any stock market in the world. It has been wrong to bet against America since 1776! The USA is still the best growth stock in the world. On the technical front, the stock market’s continued strong breadth is positive for the intermediate term. But, deteriorating momentum indicators and sentiment measures with little concern for risk suggest that the market may be overbought. We have had periodic minor corrections, but a more meaningful correction is possible followed by a resumption of the underlying uptrend. Studies indicate that it is riskier to miss market strength than experience market declines. Time in the market is more important than timing the market. The key is to have a consistent investment strategy with patience, perseverance and an “all weather” portfolio of quality companies. We believe that our investment strategy of investing in quality smaller growth companies will provide above average returns in future years because of their fundamental strength, inherent flexibility, acquisition potential, relatively attractive valuations and technical strength.