From irrational exuberance to rationalized pessimism, the equity markets provided quite a ride this past year. After recording record highs in March, most of the major indices went into decline. The one exception was the mid-cap sector. After years of under-performance, this sector posted excellent positive returns.

The most extreme ride was on the tech-a-delic, schizophrenic, manic-depressive NASDAQ! The other equity markets weren’t much better. 2000 was the most volatile year ever, with over 150 days of triple digit major index changes. The Dow, S&P and NASDAQ had record one-day point moves. The NASDAQ posted the greatest percentage one-year decline ever. The S&P 500 had its worst year since 1977. A bull market turned into a bear and the Internet bubble popped.

For 1999, the "tech" sector was the best performing group. This past year it was the worst. Three poorly performing sectors from last year (financials, oils, and health care) were among the best performers in 2000. Sector rotation from year to year is not unusual, but last year was extreme. (This is precisely why Riverplace Capital consistently invests in all sectors.)

Underneath all the volatility, equity markets had a major sea change. The markets are reflecting an economy moving from a long growth trend to one of cyclical contraction and diminished opportunities. Simply put, many growth sectors have been fully exploited for the near term. Saturation is the problem. This is true from retailing to communications; from personal computers to automobiles.

There are new growth sectors emerging. Mid-size firms exploit many of these smaller but growing niches. That may explain the relative out-performance of the mid-cap index. (That is also why our model now includes 20% mid-caps.) Some of the larger growth sectors will recover after this down turn, but not all. Typically only 30% of former leadership stocks come back to lead the next recovery phase.

The defensive sectors, such as Real Estate Investment Trust, electric utility, and consumer staple, have provided safe havens from the turmoil in other areas. Each of these areas has significant problems for continued growth, but for the time being, is seen as a port in a storm.

At the beginning of 2000, we anticipated the problems in technology and a broadening of investment performance to other sectors. We also thought we would see fair, if not exciting returns for the equity markets reflecting respectable overall profit growth. We did not see the potential for recession as being very high. That obviously has changed and did so quite suddenly. GDP grew at a rate of 5.7% in the second quarter and fell to 2.4% in the third. The fourth quarter growth may be close to 0%.

Just as we expected, interest rates have come down for most good quality intermediate and long-term bonds. At first this decline came about in anticipation of the Federal Reserve being close to completing its tightening. Then it was reinforced by the emerging weakness in the economy. (Riverplace Capital has captured good returns from its fixed income holdings. We pushed out our average life and duration targets for bond portfolios early in the year.)

Fortunately, Riverplace Capital has avoided many of the pitfalls in the environment last year and has again significantly outperformed its investing benchmarks. Our balanced approach, emphasis on quality, and good stock picking all helped.

Forget about a soft landing. We are now likely to have a hard landing or recession. In the last Perspectives we put the probability of a recession in the New Year at 25%. We would now increase that estimate to 40%. Soft landings have been rare, but not impossible. They require luck and a soft touch by the "Fed".

The "Fed" has overplayed its hand. The last ½ point fed-funds rate hike in May was overkill. In addition we have had the bad luck of an oil price spike and a hung presidential election. The oil price increase has acted as an additional tax on the economy. The hung election increased uncertainty at an unlucky time for the economy. The new presidential administration also adds many unknowns.

We expect the "Fed" to begin lowering interest rates in January. Lower rates will not turn this economy around immediately, but should mute the severity and duration of the decline.

Defensive issues, like REIT’s, utilities, and consumer staples, are likely to outperform growth stocks for a little while yet. However, many growth issues are now cheap enough to stage exciting rallies from time to time. The real question: How long will the likely economic slow-down persist?

If we experience just a few quarters of hard landing or mild recession, then the decline in the growth sector is close to being over. We are of the opinion that this is likely. (Remember markets anticipate changes up to six months in advance.)

The financial sector, which has been one of the best performers this year, is getting expensive. This is also true for many drugs and consumer defensive issues. Many technology stocks, biotech, and other high growth issues are now relatively cheaper.

Interest rates are going lower. This should occur in most sectors of the bond market. Corporates, municipals, and mortgage pass-throughs look especially attractive at his point. As rates decline and it becomes apparent that the economy is not going to fall off of a cliff, the prices of these bonds should increase. Credit quality is the key for these issues to participate in this process. Until it is apparent their credit obligations can be met, poor quality bonds may continue to trade at severe discounts to the quality sector.

The only sector that looks vulnerable to a back up in rates is long duration treasuries. Concerns may arise as to the outlook for Federal budget surpluses. Should these decline and disappear, then the government buy-back will end. The premium that these bonds command will also disappear.

Riverplace Capital introduced several mid-cap securities into portfolios in the third quarter. This continued during the fourth. During this period a few companies that proved to be weak competitors or had poor growth rates were eliminated. This is all part of a measured process to adjust portfolios to accommodate the environment we foresee. At the same time, we have kept our eyes on longer-term opportunities and have not allowed ourselves to be scared away. In short, we have adjusted our balance but remain balanced.

We are now over weighting technology after having under weighted it last year. We are now modestly under weight in oils, capital goods, and utilities. As always we continue to monitor every position. Should there be sufficient reason, we will substitute one holding for another that meets our rigid criteria.

We are maintaining our average life and duration targets at 7-9 years. We see excellent opportunities in corporates, municipals, and shorter-term treasuries. Market interest rates will decline for corporates when the depth of our economic downturn is known. Because we believe that this will be relatively shallow, we are buying these bonds now.

Municipal rates will come down further when it becomes obvious that the upper marginal tax rates are coming down only modestly, if at all. Short-term treasury rates will decline as the "Fed" eases. This is likely to begin this month.

We are de-emphasizing intermediate term treasuries as we see little potential reward and increasing risk from here. We do not use long-term bonds.

At Riverplace Capital, we liken the investing process to going to sea in a sailboat. We know that we need to be prepared for many contingencies. Storms are possible. We may be becalmed and not able to make progress from time to time. Breakdowns are likely. Crewmembers could become ill. And we may need to adjust our course and timetable.

In investing, the portfolio is the boat in which we put to sea. A large boat can take more of a storm than a small one. This is generally true for portfolios. Allocation between stocks and bonds helps weather a storm in one or the other of these markets.

From time to time it may appear that little or no progress is being made. But just like the weather, markets change too. Just when one may be inclined to give up on ever moving again, a good wind can come along and produce excellent returns and progress in a short time. Since 1982, if an investor missed the top 30 days in the stock market, their average return would have been less than 5% rather than the actual +15%.

Occasionally, an individual investment may not pan out. This is like losing a crewmember. If you started with more than you need, progress need not be impaired. In your portfolio, this is represented by diversifying and spreading your risks. You may diversify by including many holdings, and further reduce risk by making sure that they are not overly concentrated in any one sector. Individual problems may not affect your ability to experience good returns.

Sometimes it is necessary to adjust one’s course in order to continue to make progress. This may come about as a favorable wind turns unfavorable. Likewise, portfolios are adjusted to take advantage of new possibilities and avoid obvious problems. Like sailing, this is not an everyday adjustment, but a response to major sea changes. Normally, portfolios need major adjustments only about every three to five years.

This is what Riverplace Capital has been doing over the past couple of quarters. We will continue to make changes this quarter as we adjust our course. This course adjustment is to accommodate a slower growing economy and a riskier investing environment.

The last factor is the captain. Has his judgement been honed by experience and training? Does he have an experienced crew ready to meet contingencies? Has he selected and equipped a boat able to sail well, not only during good weather but also through storms? For our clients that captain is Riverplace Capital. Perhaps we should be yours. Talk with Us!

Large Cap Stocks (S&P 500) -10.14%

Dow Jones Industrial Average - 6.18%

Mid Cap Stocks (S&P 400) 16.21%

NASDAQ Composite -39.29%

Small Cap Stocks (Russell 2000) -4.20%

MSCI EAFE -15.21%

Lehman Corp. Bond Index 10.11%

(Equity indices are twelve-month returns excluding dividends)