January 22, 2002
Dow Jones Average: 9,772
S&P 500 Index: 1,128
Recovery
There are signs that the U.S. economy has stabilized after six months
of contraction. Consumer confidence is rising, closely tracking stock
prices which have recouped part of their losses. Sales at retail stores
are holding up better than analysts expected. Expenditures on big ticket
items such as homes and cars continue to be robust. Travel is slowly
returning to normal as terrorism recedes from the front pages.
The consensus among investors is that the incipient recovery will gain
momentum, reviving corporate profitability by the second half of 2002.
While recent consumer spending trends lend credence to this assumption,
there are other pressures weighing on an economic recovery. Alan Greenspan,
Federal Reserve Board Chairman, has cited low profitability as one of
the main obstacles to sustained recovery. Profits disappear when companies
have to offer incentives, such as zero percent financing, to lure reluctant
customers. As profits go down, layoffs of employees increase. Reports
of widespread unemployment makes people tentative about spending money.
The government has done everything in its power to encourage spending.
Sales of cars, computers, houses, and other expensive items are directly
related to how much debt consumers and businesses are willing to carry.
The Federal Reserve has cut interest rates a record eleven times in
one year in an effort to ease the burden of carrying debt. The U.S.
government has sent people tax rebates and lowered tax rates in the
hopes of increasing consumer spending. The downpayment for buying a
house has come down from the customary 20 percent to the 5 percent range,
sharply expanding home sales and mortgage debt. While these injections
of credit have stimulated short term demand, they are likely to retard
future economic activity as incomes are consumed by debt repayments.
The recession may be abating, but a quick return to the kind of growth
experienced several years ago is unlikely. Record levels of household
and business debt put a cap on further credit driven growth. Over capacity
in communications, steel, autos, and many other sectors reduces profitability
and employment. Recessionary conditions would be far worse were it not
for the relatively stable service sector. The millions of people employed
in teaching, health care, banking and insurance, law and government
jobs, continue to earn and spend their dependable incomes. Retirees
who collect the hundreds of billions paid out by social security and
private pension plans are another group of reliable consumers. While
the U.S. economy is broadly based and resilient, it is unlikely to produce
in the next twelve months the kind of growth and profits that investors
expect.
Current Strategy
Most of the big gains we have made for our clients have come from
going against consensus opinion. By the time a firm consensus has developed
it is usually too late to gain any investment advantage. Joining the
crowd more often results in losses instead of profits. In the past few
years the consensus opinion among investors has been consistently wrong.
Two years ago heavy exposure to the "new economy" tech sector
was considered essential to portfolio performance. Nothing could have
been further from the truth. One year ago the pundits said that big
stock market gains always follow a series of interest rate cuts. The
Federal Reserve Board has cut rates eleven times in one year and the
stock market has declined. Widespread predictions of a strong economy
in the second half of 2001 also proved incorrect. We have found that
by carving against the grain one is more likely to create a well crafted
portfolio.
There is always an element of uncertainty in any stock market investment.
Successful analysis is a process of reducing the level of uncertainty
through the research of company material and the contemplation of various
business scenarios. We are always looking
for investment situations that we can understand and that lend themselves
to a careful appraisal of risk and reward. Many other investors are
willing to take on more risk, afraid of missing out on something big.
When more aggressive investors drive stock prices higher our choices
become more limited.
Stocks continue to be expensive by most investment measures. It will
take more than a modest market decline to correct the enormous overvaluation
reached two years ago. Stock prices have generally declined, but the
price to earnings ratio for stocks has remained high as earnings have
also eroded. The median price to earnings ratio for stocks is higher
than it was two years ago. Even in this overvalued environment, we do
see a few interesting opportunities developing, as discouraged investors
punish some of their former, favorite stocks.
We have added another category to the fixed income part of portfolios
with the purchase of U.S. Treasury Inflation Protected Securities. These
bonds pay an investor about 3.6 percent per year and rise in value at
the rate of inflation. In years where inflation runs at 2.5 percent
( the long term average) the bond gives the holder a total return of
6.1 percent (3.6 + 2.5), and the return is exempt from state income
taxes. We consider these bonds a good complement to the government agency
bonds we have purchased in the past. The bonds can be sold in part or
in full any time money is needed for stock purchases.
