A Word From The Advisor

It has been a month since U.S. commercial aircraft were commandeered by terrorists and were flown into the World Trade Center, the Pentagon and the Pennsylvania countryside, creating fireballs that killed 5,000 people, melted the twin towers onto the streets of New York and dashed any sense of security Americans had previously felt on their own soil. Our initial horror gave way to grief and anxious compassion as images of the crippled buildings and their doomed and desperate occupants were replaced by those of dogged rescue workers who still scramble as if hard work alone could somehow reverse what happened.

But it was not to be. The unspeakable tragedy has been all too real. As soot and ash rained onto the New York Stock Exchange the U.S. stock market closed for four days, the longest period of downtime since the outbreak of World War I. The Federal Aviation Administration closed all U.S. airports for the first time in aviation history and countless other businesses shut down as travel and tourism ground to a halt.

Just as Hollywood special effects seem amateurish and trivial after having dealt with true catastrophe, it may similarly seem ignoble and insensitive to focus on the capital markets in the wake of such total devastation. But, as we noted in our September 24th client letter, we have confidence in the spirit and strength of this country and believe that moving constructively ahead with what we do furthers, in a small way, an orderly marketplace which, in turn, thwarts a major intention of the terrorists. In other words, it is important to get back to business as soon as possible.

The stock market’s re-opening on Monday, September 17, 2001, touched off the second largest weekly decline in the 105 year history of the Dow Jones Industrial Average, a decline of -14.5%. The Standard and Poors 500 (“S&P 500”) had a decrease of -11.5% and the already-beleaguered NASDAQ Composite fell -16.1%. It was the worst week in the market in 60 years. By month end the year to date decline in the S&P 500 was –20.4%. While some improvement has recently been evident the stock market will likely remain quite volatile as events unfold and we move into the third quarter earnings reporting season.

Declines in the stock market of 20%, while unnerving and completely undesirable, are not that unusual. The stock market has declined more than 20% eight separate times since 1970. You may recall that the 1987 decline was in excess of 22% in one day. In every case but one, the market was higher than the start of the downturn eighteen months later.

It is also important to remember that bond returns this year have been quite good. The Lehman Brothers Government/Corporate Index is up 8.4% for the nine months ended September 30, 2001. Bonds, within the context of a balanced portfolio, offer excellent risk reduction characteristics and, in a lower interest rate environment, have generated very respectable returns.

What’s Ahead for the U.S. Economy?

Most likely, a recession is ahead for the U.S. economy. In fact, we may already be in a recession. It is important to note, however, that recessions are always followed by recoveries and that recoveries generally bring higher stock prices. In each of the nine recessions that have occurred since the end of World War II, investors who purchased stocks in the midst of recession would have been very handsomely rewarded in the ensuing years.

Why is the Economic Downturn Likely to be Short Lived?

1. The government can and will spend. Not only was the $40 billion immediate aid package approved but the government will also spend sizable amounts of money on the airline industry bailout as well as on airport security systems and the Federal Air Marshal Program. In addition, an unknown amount of money will be spent on the war against terrorism. Furthermore, the $40 billion in tax rebates returned to taxpayers this year will be followed by even larger tax reductions next year and new tax reductions are being contemplated depending on how deep and prolonged the economic downturn becomes.
   
   
2. The Federal Reserve Board (“Fed”) has been actively reducing interest rates in order to stimulate economic activity. Nine interest rate declines in just over nine months is an almost unprecedented level of Fed activism. Furthermore, with inflation under control, the Fed has the ability to undertake additional ease, if it becomes necessary.
   
   
3. The banking system is in very good shape. Not only are U.S. banks large and well diversified they are also not saddled with “Less Developed Country” loans, as in the early 1980’s, “Highly Leveraged Transaction” loans, as in the late 1980’s, bad real estate loans, as the Japanese banks are, or the Savings and Loan bailout, as in 1990-91. The banks do have their share of dot com loans, venture capital operations and consumer credit card exposure, which are worrisome in this downturn, but most banks indicate that their exposure is manageable.
   
   
4. Consumer wealth is more diversified than in previous cycles. While there are large numbers of people in this country admittedly living in desperate circumstances, the majority of the U.S. work force has Social Security, a 401(k), an IRA, unemployment insurance, health insurance, a home with substantial equity, some savings or common stock holdings outside a retirement plan and, most importantly, at least two wage earners in the household. Historically, layoffs from highly cyclical industries entailed severe belt tightening but today’s workers are less loyal, less unionized and more mobile. They are likely to simply pick up and move to where the work is.

What’s Ahead for Stocks?

Buying stocks during recessions has been an excellent strategy for earning above average returns over time. The compound annual rate of growth on stocks has been +11.1% since 1926 and +12.9% since 1970, returns that substantially outpace those earned on bonds or money market instruments.

Cash in money market funds relative to the overall value of U.S. stocks is at the highest level since 1982. Money market balances traditionally are transient as these balances eventually find their way into more “permanent” investments, such as bonds or stocks. With interest rates near historically low levels and a generation of investors predisposed toward common stocks, it is likely that a large portion of these balances will be invested in stocks. This process, once underway, could represent a powerful source of demand.

On the supply side, the relaxation of Securities and Exchange Commission (“SEC”) requirements for corporate stock buybacks has increased the pace of corporate purchases of common stock. In addition, an economic downturn, for many industries, enhances the urgency of remaining competitive leading to a healthy pace of merger activity, which also removes common stock from the marketplace.

Remarkable in the wake of the tragedy is what did not happen. The U.S. financial services infrastructure did not fail; in fact, it operated without a hitch. Despite unprecedented physical damage, disaster recovery systems worked so there was no significant loss of financial information and no unreasonable delay. We are aware of a few unsettled trades (not ours), some actual checks that were lost at a bank clearing operation (not yours) and some information reported lost at the SEC. One of our database providers, whose New York operations were completely destroyed, quickly implemented disaster recovery in Philadelphia and was only one day late updating prices once trading began. Clients and competitors helped each other; facilities, communications and utilities personnel worked overtime and the New York Stock Exchange readily handled one of its highest volume days ever when it re-opened on September 17, 2001.

If a recession represents such a stellar buying opportunity, why are you holding over 10% cash in equity portfolios?

As mentioned in our September 24th letter we remain concerned over the market risk associated with third quarter earnings which are in the process of being reported. Secondly, during recessions, price/earnings ratios have, in the past, bottomed out at lower levels than those at which they currently sell. While there are many reasons why price/earnings ratios may remain off their previous lows, segments of the economy do remain expensive. Third, the tragedy has substantially shaken the travel and leisure industries and has had a deleterious effect on investor and consumer confidence. These direct results of the terrorist activity may cause the recession to be worse than we expect. Fourth, the cost of the war on terrorism, in terms of both materiel and loss of life, is as yet unknown. These factors inject a sufficient level of uncertainty into the investment arena to make holding a modest cash position prudent at this time. As these concerns dissipate, we will become more aggressive with the investment of our clients’ cash reserves.

Our message remains the same: (1) examine your goals carefully within the context of recent events and the downturn we’ve been experiencing; (2) if your investment objective properly reflects your risk profile, stay the course. The WORST time to sell stocks is during recession; (3) Try to avoid basing an assessment of your wealth on the amount of money you had in August 2000. Nobody sold his or her stocks at the very top; (4) Take a longer term perspective. Stock investing requires at least a five year time horizon; (5) Have patience – allow the plan you have put in place to succeed.

As always, if this difficult market causes you undue concern, please give us a call to discuss other investment strategies.