Worst 30 Months in Stocks Since 1941 - But is There a Rainbow?
Market Now Cheapest Since 1980

We’ve all heard the numbers with respect to stock market results for the third quarter and the year to date: the worst quarter since 1987, the worst 30 months since 1941. The negative superlatives appear endless, seemingly limited only by the historic databases of media statisticians.

Not that the market downturn isn’t serious. The S&P 500 has given up nearly a third of its value in six and a half months, having declined 32.4%, intraday high to intraday low, since March 19th. For the third quarter alone the S&P 500 price decline was -17.6%, the worst quarterly result in 15 years. For the year to date the index price decline is approximately -30% and, from its 2000 intraday high to its October 7, 2002 intraday low, the S&P 500 is down -50%, exceeding the peak to trough decline in 1973-74 by several percentage points. The besieged NASDAQ Composite has experienced a price decline of -41% for the first nine months of this year and a peak to trough decline since 2000 of -78%, again far exceeding the high to low declines experienced in the 1973 - 74 downturn.

Of the major market liquid asset classes, only bonds continue to reward investors. For the third quarter the Lehman Intermediate Government/Corporate Index experienced a total return (combination of income and appreciation) of +4.5%, bringing the total return for the year to date of that index to +7.7%, generous results indeed when adjusting for risk. Longer term bond investors achieved a third quarter total return of +5.3% in the Lehman Government/Corporate Index, bringing the nine month results in that index to +8.7%.

There’s not much doubt that external events and the economy have played havoc with the market this year. Concerns about a “double dip” recession, which stalled the fourth quarter 2001 rally, were soon supplanted by corporate mala fide behavior, accounting irregularities, high-level government probes, spectacular multi-billion dollar frauds and bankruptcy filings as factors keeping the stock market on the ropes. This past quarter, however, these issues began to be replaced by much more old-fashioned market concerns - the fragility of the economic recovery and the viability of improving corporate earnings. These factors, along with the imminence of a potential war with Iraq, have resulted in a punishing decline in stock prices over the last three months.

As common stock investors lick their wounds and stare at the financial pages like deer in headlights, they must wonder whether or not there are any glimmers of hope. We believe there are several:

1. Stocks are cheap or, at the very least, reasonably priced. The much-watched Fed model of equity prices compares the forward earnings yield on the S&P 500 (that is, the inverse of the estimated price/earnings ratio) to the yield on the 10-year U.S. Treasury obligation. With the yield on the 10 year Treasury now at 3.65%, stocks are cheaper than at any time since 1980.
   
   
2. Corporate earnings really are on the upswing. The core Producer Price Index (“PPI”), a measure of inflation at the producer level, is highly correlated with corporate earnings growth. Quietly, the core PPI has been increasing and, in July, hit a two-year high. As producers gain pricing power, because of increasing demand, low inventory levels and capacity obsolescence, the core PPI should continue to accelerate. S&P 500 operating earnings can, therefore, be expected to increase as well.
   
   S&P 500 operating earnings increased 32% from a year ago, once 2002’s second quarter results were in. While estimates of 2003 earnings may still be somewhat aggressive, the fact remains that a powerful earnings recovery has begun.
   
   
3. The economy is fine and there will be no double dip unless there is a protracted conflict in Iraq. U.S. Gross Domestic Product (“GDP”) grew at an anemic 1.1% in the second quarter of 2002. However, since the first quarter of 2000, the value of household marketable securities has declined by $8 trillion. As huge as this number is it was offset by a $7 trillion increase in the value of household real estate. Thus, until recently, the wealth lost in common stocks was almost offset by an increase in the value of real property. During the third quarter, however, the loss in the value of equity holdings finally exceeded the gains in real property. This phenomenon, or negative real wealth effect, will remove half a percentage point from the consensus GDP forecast for 2002. Thus, this year’s GDP consensus will center around our long-estimated 3.5% increase. One major risk to this forecast is the impact of the West Coast dockworkers labor dispute which, if it became protracted and contentious, could stall economic activity and exert a negative effect on U.S. economic growth. We continue to estimate that the U.S. economy has the ability to grow by 4.0% in 2003.
   
   
   
   All eyes are on the habits of the U.S. consumer whose ability and propensity to consume has kept the economic downturn from being a lot worse. Consumer spending slowed in the second quarter, rising at only a 1.9% rate. However, the continued lure of zero percent financing resulted in vehicle sales turning in the fifth fastest month on record in July, contributing to a 3.5% rate of growth in consumer spending. Because the pace of vehicle sales is likely to slow, we expect consumer spending to moderate in the fourth quarter. Year over year growth in consumer spending is expected to come in at +3.0% in 2002, accelerating to +3.4% in 2003.
   
   
4. The Iraq war will most likely be short-lived and its long term economic impact comparatively small. Despite Iraq’s decision to allow UN inspectors back into its country we continue to believe that armed conflict remains a high likelihood.
   
   The major economic risk of war in Iraq is, of course, an increase in the “war premium” in oil prices. The current price of oil, at around $30 per barrel, could spike to $40 per barrel in the event of full-blown war. This is especially plausible in view of the fact that inventories are already extremely low. At current levels of supply, every $1 increase in a barrel of oil increases gasoline prices by about 15 cents and every penny increase in gasoline cost takes $1 billion out of consumer spending. Because other necessities are also affected by higher oil prices (fuel oil, the cost of transportation) a spike to $40 oil could remove approximately half a percentage point from GDP growth next year.
   
   Such oil shocks in the past have acted as triggers for recession, both in the 1973 - 74 inflation spiral period and in the 1990 - 91 Gulf War period. Hence, observers worry that an Iraq war will create the much discussed economic “double dip,” sending the U.S. economy plunging into another recession.
   
   
   
   We do not think this is likely. In 1990, for example, labor markets were tight, inventories were high and the U.S. economy was about to enter a recession. Inflation expectations were around 4% and taxes had just been raised. Today, labor markets contain slack, GDP is under its potential and inventories have been slashed. Inflation expectations are just below 2% and taxes have just been reduced. In short, the economy is better positioned today to withstand the economic cost of war than it was in 1990.
   
   It is expected that President Bush is not likely to endanger Americans prior to Christmas. This puts the conflict into January 2003 at the earliest, giving the U.S. economy another quarter to gather momentum on its own.
   
   Most experts conclude that an Iraq war would be swiftly resolved. If this proves to be the case oil prices would correct quickly and the negative impact on financial markets would be short-lived.
   
   
5. There is no housing bubble. Despite some regional imbalances, the housing market remains excellent. August new home sales rose 1.9% aided substantially by historically low mortgage rates and favorable demographic trends.
   
   The real indicator of a “housing bubble,” of course, are the trends in housing prices. Increasing prices peaked two years ago and, since then, the rate of increase has declined. At present, prices are still up 4% nationwide. Assuming that the worst of the recession is behind us there was no housing price bubble and, if there was, it didn’t burst.
   
   
6. The capital stock is not overbuilt and capital spending is not dead. Except for telecommunications, much of which is in or near bankruptcy, the capital stock of this country is not overbuilt. What overbuilding existed has been worked through during the capital spending collapse of last year. Now that corporate earnings are in recovery, attention can be turned to expansion, especially given recently enacted tax incentives.
   
   
   
   
7. The industrial sector isn’t growing very fast but it is growing. The latest Institute of Supply Management (“ISM”) survey shows a reading of 49.5, just below the 50 level, above which the economy would be expanding. However, the services segment (that is, non-manufacturing) was up to 53.9, the eighth month of above 50 readings, and indicative of solid expansion.
   
   The inventory liquidation cycle appears to be complete as manufacturing inventories were unchanged after declining for eighteen months straight. Such a circumstance sets the stage for inventory rebuilding over the coming months which would be very positive for economic activity.
   
   
8. Interest rates remain low and inflation is non-existent. The year over year rate of increase in the Consumer Price Index (“CPI”) is just 1.5%. Declining prices of goods - down 1.4% in the past year - are being offset by modest inflation in the services sector, up 3.5%. Our estimate of inflation for this year, 1.6%, appears on track but, if low, should remain below 2%.
   
   As we have noted many times, low inflation takes pressure off the Federal Reserve Board (“Fed”) to undertake preemptive tightening. As the economy remains weak and the Fed has retained an easing bias, we’re hard pressed to suggest that there will be any move to tighten interest rates this year.

Market participants have been pounded this past quarter, indeed for the better part of 30 months. But a recovery in earnings and economic activity, along with the anticipated “manageability” of the Iraq war, are the stuff of which market rallies are made, not the fuel for a further decline.