Equity Market - Strategy

The slowdown in economic activity and the attendant contraction in corporate earnings have combined to disappoint common stock investors this year. For the 12 months ended June 30, 2001 the Standard and Poors 500 (“S&P 500”) has declined 14.8% and is down 6.7% for the year to date. The beleaguered NASDAQ Composite, with its concentration of technology stocks, declined 45.5% in the last 12 months and is down 12.6% for the year to date.

If we have successfully avoided an actual economic recession we definitely are IN a full blown earnings recession. In fact, the magnitude of continuing earnings shortfalls from expectations is downright embarrassing. Advanced Micro Devices just reported that they will earn less than one-fifth of the amount analysts had expected for the second quarter, due to pricing pressure and slumping demand for its flash memory chips. Whoops! Keep in mind that these are shortfalls from ALREADY REDUCED expectations.

For the second half of the year earnings should stabilize. The damage attendant to the NASDAQ collapse has been significant but estimates are much lower now so further disappointments from expectations is likely to be less dramatic.

We expect that the second quarter, being reported now, will represent a nadir in profits for the year. For 2001 S&P 500 earnings will decline 7% before making an excellent rebound next year, probably up in excess of 15% if current estimates for 2002 are met. This puts our operating earnings estimate for the S&P500 down to $51.00 for 2001 and up to $59.50 for 2002.

While there is every expectation that a market advance will resume, there are still huge structural issues that must be solved. Chief among these is the fact that the stock market is not yet classically “cheap.” While we dealt at length last quarter with a rationale for why price/earnings multiples did not necessarily have to go to the lower end of their historical ranges, we did acknowledge that they could go to 18 times earnings or so and not violate the spirit of our analysis. At present the S&P 500 is selling at 19.9 times estimated 2002 operating earnings.

The price/earnings ratio of the market may appear even cheaper next year, all else equal, for reasons having little to do with earnings. Recently, the Financial Accounting Standards Board (“FASB”) altered the accounting methods by which companies account for mergers and acquisitions. Essentially, “goodwill” and the ability to amortize it over time is being completely eliminated under the new rules. The result of this will be to eliminate a charge to earnings for many large S&P 500 companies which will immediately increase net income. With the “E” in P/E ratios moving higher, price/earnings ratios correspondingly move lower. For this reason, we believe that the market is actually cheaper than it looks.

In terms of portfolio structure, our most important underweighting is in the technology area where we are approximately 25% underweighted versus the percentage of the stock market invested in technology. Within this sector we prefer companies with solid business plans and the ability to generate earnings, even in a slowing environment.

We are also underweighted in consumer staples in the belief that these companies have reached the point where they will have limited ability to further reduce costs. We are underweighted in health care but will move to at least a market weighting within the next few weeks. The attractive growth rates and stability of earnings of the major drug companies more than offset near term concern about pending legislation. We also remain underweighted in utilities as that industry sorts out its opportunities in both regulated and unregulated businesses.

We remain overweighted in the capital goods area, participating primarily in broadly diversified “best idea” companies whose results have been less affected by the recent downturn in economic activity. We have also overweighted consumer cyclicals in anticipation of a consumer led recovery in the second half of this year. In addition, we remain overweighted in financials, which continue to sell at very cheap historical price/earnings multiples.

We have moved from an overweighted to a market weighted position in raw materials, as we were able to realize some profits recently and simultaneously reduce portfolio risk. We are also market weighted in communications services, preferring companies with recurring revenue streams to those on the leading edge of technology as a more risk averse way of participating in the telecommunications industry these days. Additionally, we are market weighted in the energy group, emphasizing oil service companies as we believe the oil industry will continue to meet the long term demand for energy by engaging in exploration activities, especially in years following peak profits.

We believe client portfolios are properly positioned for the upturn, being fully diversified and owning the shares of companies which have identifiable competitive advantage, superb financial controls and excellent management. In the meantime, however, the modest cash position we maintain offers some downside protection in the event the market rally is delayed.