A Word From The Advisor

It is not difficult to figure out that the stock market at present is being held captive by the progress of the Iraq War. When economic data are pretty good the market can still sink if war news appears to be negative for the Allies. When corporations report positive results or make optimistic forecasts, stocks can still nosedive if, simultaneously, the media report that Allied troops are awaiting supplies just south of Baghdad and can’t move forward or that an ambush appears to have killed several soldiers. Clearly, the stock market wants to see a definitive and early resolution to the war in Iraq, including the elimination of the current regime and the neutralization of Iraq’s weapons of mass destruction.  At this moment, things seem to be going well for the Allies and, predictably, this has been reflected in a market rally that reversed the negativism the market had been evidencing and resulted in the Standard and Poors 500 (“S&P 500”) generating a very small positive total return for the year to date through April 7, 2003.

Until the recent rally, however, the U.S. stock market had clearly been discounting a short war in Iraq that would be quickly and cleanly executed and result in a minimum of U.S. casualties. News to the contrary had heightened uncertainty and wrought havoc with investor confidence. It was those uncertainties that caused the 14% pullback in the S&P 500 in this year’s first quarter, from the high attained on January 14, 2003 to the low on March 11, 2003, a nadir which brought the index within just 3.0% of its October 2002 low.

While the market remains captivated by the armed conflict in Iraq and is likely to remain so, we think it’s important to focus on the events that will shape the post-conflict environment, with a view toward determining what market conditions will be like. To us, both the economy and the stock market in recent years have resembled “rope-a-dope,” the allegorical boxing term in which a boxer is punched up against the ropes until he is “dopey.” First, there was the well-publicized technology “bubble” and telecommunications overcapacity meltdown which began in 2000 and has continued to this day. Then the 9/11 attack occurred. Following this, the energy crisis and the Enron bankruptcy commanded the markets’ attention. Then a very serious manufacturing recession hit the economy. This was followed closely by a series of accounting scandals and evidence of corporate skullduggery at some of the biggest and most respected companies in the land. Finally, we have gone to war. With all of these punches being thrown at the American economy, one has to wonder: what would happen if the punches simply stopped? In other words, would an absence of negative events get the U.S. economy off the “ropes” and give positive impetus to the stock market?

As we examine what would happen if the punching stopped, it is important to understand just how pervasive the current environment has become. Just as concern over the portent of war eroded consumer confidence it has also hampered business activity. Until very recently, capital spending was in a serious slump, as evidenced by the fact that inventories have not been rebuilt at the rate that had been expected. Furthermore, the Institute for Supply Management (“ISM”) index surprisingly fell in March to a level which indicates that manufacturing activity is once again contracting. Higher energy costs created a drag on national income nearly a full percentage point greater than existed last year. Thus, U.S. GDP is likely to have grown only about 1% in the first quarter of 2003, not a level that looks much like an economy in the robust early quarters of a recovery.

A quick resolution to the Iraq conflict would bring sharply lower oil prices to the U.S. Already, West Texas Intermediate Crude is selling near $29 per barrel after touching $38 in the days just prior to the start of the Iraq War. Inventory rebuilding must yet be accomplished and this will require increases to capital spending. These events, combined with help from near term easing by the Fed, could create a more robust economy later this year. In addition, we cannot forget that the impact from last year’s tax cuts has yet to work its way through the economy. Finally, it is clear that once the war is over, President Bush’s attention will focus on the American economy. It is expected that the president and his team will pull out all the “economic stops” in order to get growth underway in time for the 2004 election.

We urge investors to avoid the trap of emotional investing. The Iraq War will not remain at the forefront forever. But with all the uncertainty surrounding the war, some investors are asking why they should invest in common stocks at all?  Why not sell common stocks and wait for the uncertainty to be resolved?

Waiting for uncertainties to be eliminated from the marketplace will almost certainly result in missing a significant portion of any upward move the market experiences. Nearly a third of the twenty-five percentage point move that occurred from low to high in the market after the September 11, 2001 terrorist attacks occurred in the week following the September 21, 2001 bottom. Those waiting on the sidelines for the market to bottom missed this move. The point is that staying in the appropriate percentage of stocks that fits with your objectives will allow full participation in any upward market move and will ensure that you do not miss those dramatic early moves.

Some other examples of recent market reactions to shocks are also instructive. In the three months following Iraq’s invasion of Kuwait in August of 1990 the stock market (as measured by the S&P 500) fell 20%. Yet in the subsequent three and a half years (until the 1994 round of interest rate increases that stalled the market for a year) the market appreciated 64%. After the Fed-induced economic slowdown in 1994 stocks DOUBLED in the subsequent three years and appreciated another 70% in the nine quarters after that. The Asian tiger meltdown in the third quarter of 1998 took the market down 22% from high to low prior to a 68% increase in the next year and a half. Even the 9/11 disaster saw a 25% increase in the S&P 500 in the months following that event before war uncertainties and a weak economy occasioned a resumption of the bear phase. More recently, the market rallied from its October 9, 2002 closing low, a bottom that has so far represented the absolute nadir of a three year bear market.

The point is that shocks to the market, even significant ones, are eventually reversed, resulting in sharp and frequently significant moves upward in stock prices. Because these reversals happen very quickly investors are best served to retain an appropriate level of common stock exposure, even in volatile and uncertain environments.

Once the conflict in the Middle East got under way in 1991 the market was able to improve. Despite the conflagration in which we are currently engaged, the market dislikes lingering uncertainly far more than it dislikes individual disasters. Hence, the fact that U.S. action is underway is actually positive. History instructs us that the negative market effects of an individual event are more often than not quickly built into stock prices, setting the stage for later relief.