Recovery – January 2002

January 22, 2002

Dow Jones Average: 9,772
S&P 500 Index: 1,128



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.

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