Second Quarter, 2002

Not since the Depression have the broad stock market averages been down more than two years in succession. This year is tracking to become the exception as the third year in a row that stock markets have been down. For the six months ended June 30, the S&P 500 and the Dow were down 13%, while the NASDAQ was down 25%. The impact of this difficult market has been softened considerably in client portfolios by reduced level of stock exposure and by largely avoiding the ravaged tech sector.

Continuing improvement in various economic statistics has had no effect to date on stock market psychology as a variety of other factors have led investors to begin "throwing in the towel." This picture of the economy being on the rebound while the stock market continues to swoon has plenty of precedent. For example, from 1964 through 1981, the Dow Jones Industrial Average had no gain while Gross Domestic Product (GDP)—a proxy for overall economic growth—increased by 374%. Thereafter in the bull market from 1981 through early 2000, GDP grew a total of 197% while the Dow rose 1,239%. (See the chart accompanying this letter.)

For the first time since domestic stock markets began to decline in mid-2000, the term "secular bear market" is now being mentioned in the popular press. It's not a pleasant thought. Secular bear markets don't care about favorable economic statistics, GDP growth, actions taken by the Federal Reserve, or Presidential proclamations.

The one thing that matters above all is valuation. In a secular bear market, stocks return to attractive valuations and in many cases, undervaluation, as collective investor emotion swings to panic. Based on the history of past market bottoms, this would imply much lower P/E levels and much higher dividend yields than those of today's stock indices. However, stocks are financial instruments and valuation is closely related to interest rates. With today's rates at 40 year lows, stocks don't have to drop all the way to the level of previous market bottoms to become attractive again.

Which way will interest rates go? This question gets to the heart of the matter, and as you might expect, the analysis is clouded with conflicting data. In order to stimulate spending and prevent a relapse into recession, the Federal Reserve has been expanding the money supply at an extraordinary rate, which should lead to a cheaper dollar relative to the currencies of other countries, increased inflationary forces, and ultimately, higher interest rates to ward off inflation. At the same time, deflationary forces continue to grow in all things manufactured as overcapacity is deemed to be rampant in most areas of manufacturing. China continues to grow as an economic powerhouse, producing quality manufactured goods at a fraction of the price found elsewhere in the world. China, and soon Russia, will be bringing deflationary pressures to the rest of the industrialized world for years, if not decades to come.

In housing, the inflationary effect of the Fed's easy money policy is plainly visible. Home prices are escalating at rates far above GDP growth and personal income growth. Cheap money has made it possible for Americans to leverage up their homes and use the cash generated to continue the consumer spending spree widely discussed in the press. More than any other factor in our opinion, the consumer has kept the economy alive by spending money generated by increasing their personal debt. A collapse in this growing housing market bubble caused, say, by rising unemployment and/or rising interest rates, would have ramifications far worse to the average American than anything experienced by the hapless tech investor. Recession, Phase II, would then be upon us.

Finally, there is the dollar. Treasury Secretary O'Neill has made it clear that he doesn't intend to defend the dollar from declines relative to other currencies, saying "I am in favor of doing whatever I can to help exports." Currency traders view this as carte blanche permission to bring down the dollar as far as global market forces will allow. Foreigners investing in the U.S. now are experiencing not only losses on their equity investments, but currency losses in addition. Foreign purchases of U.S. investments have declined precipitously this year. Downward pressure on the dollar will eventually lead to higher interest rates which will be needed to once again attract foreign depositors whose investments fund our growing deficits.

Other inflationary forces are beginning to build: fighting the war on terrorism (all wars are inflationary), the trend toward increased government regulation and interference in financial markets, rising government deficits, and increasing protectionist policies in the new era of global "free trade."

Here's how we are navigating through these turbulent waters with client portfolios:

1. We continue to hold stocks near the low end of our agreed-upon equity range (nothing new here.) However, we do note that an increasing number of stocks we like are selling at valuation levels not seen since the beginning of the 1990s.
2. We continue to increase portfolio yields. This is cash coming into client accounts from dividends and interest which we can invest in additional securities when market conditions warrant. Cash flow is now extremely important as a means to preserve the value of a portfolio.
3. We continue to hold bond maturities at the shorter end of the maturity spectrum as we wait for inflationary forces to reappear and result in rising interest rates. We think the forces of inflation will eventually win over deflationary trends. When interest rates rise, longer-term bonds decline in price more than short-term bonds.
4. We continue to maintain a position in inflation-indexed bonds whose yields will rise with inflation.
5. To offset dollar weakness relative to the euro and other foreign currencies, we have diversified a portion of many client portfolios into a fund that acquires the short-term debt of other countries.

Finally, to provide a measure of protection against the inflationary implications of the Fed's easy money policies, we have purchased shares of a precious metals fund. Historically, people around the world invest in gold to protect purchasing power. Presently, gold is extremely undervalued based on past relationships to other financial assets, and we believe its inclusion in client portfolios represents a sound diversification strategy.