Equity Market Strategy

Corporate profits declined 12.5% in 2001, making it the second worst profits year since the end of World War II. The only worse year was 1970 when profits declined by 12.9%. Moreover, that profits decline will translate to an estimated decline in S&P 500 earnings for 2001 of approximately -35%, truly a dismal year.

Fortunately, the news for stocks is getting better. Not only is the economy showing signs of improvement but every sign points to the fact that a better level of economic activity is creating a rebound in earnings. As a result, estimates for S&P 500 operating earnings per share for 2002 have been moved up to the $47.00 area with $55.00 expected for 2003. On those estimates of earnings, the market is currently selling at a multiple of 24 times 2002 estimates and 20.5 times 2003 estimates. While these multiples of earnings are not classically cheap, they are also not unreasonably expensive in view of the extraordinarily low levels of interest rates and inflation right now. In addition, as the year wears on, the market will begin to anticipate, or discount, 2003 earnings, now selling at a much cheaper multiple.

We do acknowledge that many technology and telecommunications companies remain expensive relative to their fundamental prospects and their expected earnings. In fact, if the technology segment is removed from the S&P 500 the price/earnings multiple on 2003 earnings estimates drops to 17 times, a much more reasonable number.

There may also be room for expansion in the earnings estimates as well. For example, the recently passed economic stimulus bill offers accelerated depreciation for certain capital equipment. This tax boon has the effect of lowering the corporate tax rate by about 2.5 percentage points which adds more than a dollar to S&P 500 earnings per share.

We are bothered by a rather pervasive bear market mentality that appears to have cast a pall over the stock market. As is typical of the late stages of bear markets investors are not yet “believers” that stocks can mount a serious move to the upside. Hence, each decline is met with a new wave of selling as more and more investors are shaken out of stocks. At some point, all marginal investors will have left the market and this bear phase will be over. In the meantime, the market goes through periods characterized by doubt and suspicion, exacerbated by concerns over real and perceived accounting irregularities and the specter of an extended Middle East war.

Once we see signs that the bear market phase has run its course we will become more opportunistic. For the present, however, we are pleased with the low price/earnings ratio cyclicals stocks and quality growth names that have represented most of the additions to the portfolios over the past months. Over this period, we have modestly reduced the cash balance we had held and redeployed it into securities expected to offer good price performance over the next market period.

Areas of overweighting continue to be financials and health care. The financials are selling at very cheap multiples of earnings while the health care stocks offer high quality, superb management, excellent growth and positive demographics. While the health care stocks are not cheap, we continue to believe that their excellent characteristics justify the prices at which they sell.

We are and have been underweighted in technology believing that the constituent companies within that sector are still too expensive and may still experience some retrenchment. We are also underweighted in consumer cyclicals. Most other major sectors are at or near their market weightings and contain individual selections expected to perform well in the upcoming market environment.

Common stock investors in any strategy have been asked to endure a lot over the past few years. Those who have reminded themselves that they are in this for the long term and who are satisfied that they are adhering to a cogent and viable strategy will find that their patience will be rewarded.