Third Quarter, 2001

Summary

We are in the middle of a global recession which appears to be worsening at the present time. Its duration is unknown and its uncertainty has been heightened by terrorism. At the same time, domestic stock markets remain high by historic valuation methodologies. Optimists (banks, brokerage firms, politicians, the media) remain convinced that economic recovery is one or two quarters away and that now is the time to be acquiring stocks at prices that will look very cheap a few years from now. Pessimists believe that we are mired in a primary bear market that will last until excellent value is restored across stocks as an asset class. Its time frame cannot be predetermined.

Our views, and consequently our actions, lean towards the pessimist camp at the present time. Our investment decisions during the past 3 months have been more heavily weighted towards preserving your investment assets as opposed to trying to maximize portfolio growth.

Discussion

Political and economic changes are unfolding with such rapidity at this time that many investors are being traumatized into inaction. This is what we hear from investors who are not our clients: "I guess I’ll just sit out this bear market and wait for the recovery. My stocks are down so much already, it hardly makes sense to sell them now." This thinking is reinforced by two persistent themes that are continuously hammered into our heads every day, courtesy of the media. We have all been thoroughly brainwashed to believe that:

1. We’re in this investment game for the long haul, so why succumb to short-term sell-offs or bear markets; and

2. Alan Greenspan and the Fed will bail us out. Short-term interest rates have now been lowered on nine separate occasions and we are told that the Fed will keep on lowering rates until the economy stops sputtering and starts humming again. This kind of dogged determination has always succeeded in the past, right?

Over the years, we have said many times in these quarterly letters that investors should not only be wary of any consensus view, but rather should trust it as a contra-indicator. Regarding the first argument raised above, sure, we’re all long-term investors, but not necessarily with a blind obedience to stocks all the time. During the past 75 years, there have been many extended periods of time when stocks have delivered negligible returns or losses:

The point here is that the appropriateness of long-term stock investing is heavily dependent upon 1) how investors define "long-term," 2) your starting point, and 3) the time frame for drawing down your portfolio. Bear markets, as illustrated above, can continue for painfully long periods of time and many investors, especially today, can’t afford to wait for a future recovery.

The second prevailing wisdom deals with expectations of success based upon Federal Reserve actions. Presently, most financial publications and other media continue to tell us that recovery is at most one or two quarters away and that now is the time to be buying stocks. We have been handed this line since January when the Fed initiated its first surprise rate cut. The stock markets are signaling otherwise – at least, through September 21. (As of the date of this letter, the recent upward spike in stock prices is too short to tell us anything.)

Why have nine rate cuts failed to inspire the stock market up to now? Interest rate reductions only work if consumers and businesses are induced to borrow and spend. Prior to September 11, both of these groups were retrenching. Consumers were growing increasingly concerned about job safety as the unemployment rate continued to rise, and businesses were facing growing excess manufacturing capacity coupled with declining sales and profit margins. After September 11, these disturbing trends were exacerbated.

How long it may take before the Fed’s actions have their intended consequences is anyone’s guess. Nobody really knows. Japan serves as a grim warning, however, of the limited power of governments to stimulate economic growth. Their economy continues to resist both government spending and low interest rates. Japan’s central bank has lowered that country’s discount rate to 0.1% (one-tenth of one percent), but the economy remains mired in a recession that appears to be worsening. Recently, the Japanese stock market hit a 17-year low. Japan, it should be noted, has other serious structural problems in their capital markets which, fortunately for us, do not have a counterpart in the U.S.

Another attempt to stimulate demand through low-cost debt is taking place now in the auto industry. Ford and GM have announced 0% interest rates on new car loans. Auto dealers report that sales have improved from mid-September levels, but purchases are by no means robust. Low interest rates guarantee nothing, especially when job losses are mounting.

If we can’t rely upon the consensus views of brokerage firms’ research analysts, government economists, politicians, and the legions of media personalities who have been fearlessly and incorrectly guiding us, where can we turn for sensible, unbiased advice? The answer can almost always be found in the price action of the financial markets themselves. Our stock, bond, and commodities markets continuously evaluate every piece of information generated around the world. Tens of thousands of people react to this ongoing flood of information each day by following up on their convictions with money invested in  various markets. Superimposed on this market action, however, is the cautionary statement that from time to time, waves of emotion create extremes in valuation in the stock market, with the tech bubble being the most recent example.

To succeed in investing, therefore, one must analyze what markets are telling us and then determine if the message is being unduly influenced by the powerful emotions of fear or greed. It will surprise no one to declare that this is no easy task.

Today, the stock and bond markets are telling us that fear of recession is growing, and that stock prices, based upon historic value relationships, are still too high when compared to past market bottoms. Selling has not yet reached panic proportions and therefore the bear market continues. In the face of a stock market moving back towards more reasonable valuations, we interpret the general investor mood to be one of complacency mixed with the resolve to wait this bear market out. The message of the media is still deeply ingrained in the minds of U.S. stock market investors.

Investors can also look to the bond markets for clues regarding the economy. Here again the news is not good. A few examples:

1. While interest rates in general have declined, junk bond yields are at 10-year highs and default rates are rapidly increasing. Junk bond market investors are anticipating greater investment risk caused by a worsening economy and are demanding higher yields as compensation.

2. The difference between yields of the highest-grade bonds and medium-grade bonds (called a yield spread) is growing wider. A widening yield spread represents the bond markets’ vote for a deepening recession.

3. Long-term government bond interest rates have experienced very modest declines in the face of dramatically declining short-term rates. The bond markets are always paranoid about the re-emergence of inflation, but at the present time, other economic indicators show that inflation is not an issue. So what is spooking long-term rates to remain relatively high in a period of economic slowdown? The message of the bond markets appears to be that deficit spending is on the way. Prior to September 11, tax receipts at the federal, state, and local level were rapidly declining. After the New York and Pentagon bombings, the situation quickly worsened and Congress and the President have agreed to spend a previously unplanned $100 billion to boost economic growth.

Yes, friends, the budget and the Social Security surpluses are about to quickly become history. August saw the largest one-month budget deficit ever - $65 billion. When the money is needed in the future to pay retirement benefits in excess of taxes collected, the government will have to employ a combination of strategies such as raising taxes, cutting benefits, or borrowing more money. If the government begins competing with the private sector for capital, it is reasonable to assume that long-term interest rates may begin to rise.

Around the world, all major regions are experiencing simultaneous recessions with the U.S. Europe, Asia, and Latin America are reporting accelerating economic slowdowns and declining consumer confidence. As of September 30, major stock markets throughout these regions all reported 9-month declines of 20-30%. The companies comprising the Dow Jones Industrial Average derive in the aggregate approximately 40% of their revenues from outside the U.S., and many attribute their domestic woes to weakening demand in the foreign markets. This leads us to conclude that a series of Federal Reserve short-term rate cuts may not matter very much in the broader context of softening global demand and excess capacity.

Back home, the consensus view is that yes, this has been a bear market, but it has pretty much run its course. ValueLine advises its readers to commit 80-90% of their portfolios to stock. A recent Forbes magazine poll reveals that 3 out of 5 investors expect double-digit returns over the next decade. Federal Reserve officials remind us that the economy is fundamentally strong. Most brokerage firm market strategists are bullish and suggest strong economic growth in 2002.

Stock markets both at home and abroad have, so far, ignored this optimism. A very tiny minority of highly respected investment professionals (Warren Buffet; John Vogel, founder of The Vanguard Group; and Richard Russell, market technician, among others) claim that we are in a primary bear market which won’t end until great values are once again offered to all investors. A great value can be loosely defined as a growth stock with a dividend yield of 4-6% and a P/E multiple in the 10 to 14 range. The Dow Jones Industrial Average, for example, would be considered a great value if it offered a 5% dividend yield as it did at other market bottoms in each of the years 1978-82, 1947-53, 1940-42, and 1931-32. A five percent yield based upon today’s dividends would call for the Dow to decline to the 3,600 level, last seen in 1992. Alternatively, the market may just bounce along, going nowhere for a number of years until growth in earnings and dividends restores reasonable valuations.

Bear markets are exceptionally difficult to navigate. It is not unusual for the stock markets to experience sharp upswings in prices, creating mini-bull markets and renewed hope within a primary bear market. After a few weeks or months, however, the gains of these mini-bull markets generally dissipate as the bear market continues on to new lows.

Making matters worse is the fact that many of today’s younger financial advisors have never managed money in a previous bear market and are thus ill-equipped to guide their clients through the malaise. We generally subscribe to the notion that this is a primary bear market that will not follow some neat rule-of-thumb timetable such as is suggested by the financial press and others. To the contrary, it is worth repeating that primary bear markets end when value is restored in the marketplace. Such a concept does not conform to anyone’s timetable.

Asset Allocation

Based upon our asset allocation analysis for investors across all risk categories, we continue to hold all accounts at the low end of our agreed-upon equity range. This reduced equity exposure has helped minimize portfolio losses in a very difficult market environment.