All’s well that ends well! The stock markets are recovering and the future looks promising. This was the second year of negative returns in the equity markets, but over the past 100 years there have never been three in a row. We believe that record is safe.

It appears to us that the bear market that started in March of 2000 ended on September 21, 2001. During this eighteen month period the Dow Jones Industrial Average declined 31%, the S&P 500 38%, and the NASDAQ a whopping 73%. In magnitude and duration, this bear market was one of the worst. Ones like this happen only a few times a century.

Sometimes bad events can lead to good responses. This is precisely what happened after the terrorist attacks of September 11. Even though the Federal Reserve had been lowering interest rates before this date, afterward they came down with a vengeance. Money supply grew by 280 billion dollars in a three-week period. The federal government promised additional fiscal stimulus, and the American people pulled together as they have not done since World War II.

In fact, it seems that the worse the economic news got the more positive our economic responses. Investors recognized that this would eventually lead to recovery and began buying equities. They invested foremost in those companies in beaten-down sectors, that would soon be seeing better days. That is why the technology, industrial, and consumer discretionary sectors have been leading the market recovery since September 21st.

In November, the economic committee that officially determines business cycles announced that, in fact, the U.S. economy was in recession and that it started in March of 2001. Officially our economy has been in recession for about nine months. This is a typical duration. Economic recoveries after recessions generally are quite robust. They normally grow over 5% for the first few quarters and that can be much higher. We are keeping our fingers crossed.

After a violent and turbulent twentieth century, we have entered a violent and turbulent twenty-first. Some things never change and economies and stock markets continue to have cycles.

It is ironic that in November when economists finally declared that the U.S. was in a recession, it was probably almost over. A tentative recovery is beginning. More so than in past cycles, this recession was in essence an inventory correction. Business in the late nineties, anticipating accelerating growth, over-invested in new capacity and built too much of nearly everything.

The process of adjusting back to lower levels for both inventories and capacity has been going on for over eighteen months. For a lot of businesses, the process is probably about over. Remarkably, consumer spending and housing activity held up very well throughout this period. If this cycle is typical, firms have reduced their inventories to "too low" levels and will need to re-stock to catch up with increasing demand. Some deferred investment will also have to take place. That is why the first months of recovery can be so robust.

sixty percent of stock market recovery to take place before a recession ends. This means that by the time the economy is beginning to grow again, much of the recovery in stock prices already will have occurred.

Technology, industrial, and the consumer discretionary stocks are leading the way. The defensive sectors, such as staples and utilities, are not participating in the upswing and, in many cases, are declining. This is because investors are selling these stocks to buy those of companies that will benefit from an economic recovery (again, technology, industrial, and consumer discretionary stocks). The maxim that markets lead economic activity by three to six months appears to hold once again.

During this recession, interest rates declined in a predictable manner. In fact, short-term rates have reached levels not seen since the early sixties. Now that a recovery is on its way, the risk to bond holders is that interest rates will start rising again. The timing and extent of increase will depend upon how robust the economy rebounds. If, as we expect, the rebound is sooner and greater than expected, then that will be soon.

Bonds with long maturities will see their market values decline. However, corporates and selective lower quality issues should do better, because an improving economy will indicate a better ability to pay interest and repay debt when it comes due. The better credit quality outlook will help offset this decline.

We are fully invested. We have over-weighted the technology, industrial, health care, and consumer discretionary sectors. We have and will remain under-weighted in the financial, consumer staple, and utility sectors. All other groups are at market weightings. This strategy is designed to benefit from economic recovery. Our relative performance during this upswing has been outstanding.

For the third time this year, we have reduced the average life and duration targets for our bond portfolios; those targets are now four to six years. Until the economic expansion is well under way, we will not commit to a longer target. We also are allowing up to twenty five percent of fixed income allocations to remain in cash equivalents. For bonds, our preference is to own high quality corporates.

A business succeeds when customers buy what it is offering and grows when they want even more in the future. The value of each enterprise is largely determined buy the profits that are made from this activity.

Like a business, if a farmer grows watermelons one year and sells them for about what it cost to grow them, then the enterprise value of the farming activity is very little. If, however, the farmer owns the land, and instead of farming decides to turn his land into a housing development, then that land has an asset value. Even if the farmer doesn’t do this with the land, but it is well located, then the alternative use determines the value of the farm.

A growth investor would be more interested in finding a farm or a firm that year in and year out makes a healthy and growing profit. A value investor might be more interested in finding one that is valued on the basis of its poor profits, but which has assets that have hidden and perhaps alternative value.

The growth firm becomes more valuable every year that it successfully sells more, and makes more profits. After all, a company that makes $10 million a year in profits is worth more than one that makes only $1 million. Unless, of course, the one making $1 million a year is sitting on valuable assets that could be better utilized. In the first company, owners see a regular increase in the value of their stake. In the second instance, owners may need to sell the underlying valuable assets in order to realize their true value. Or if it is a stock, when the true value of that stock is realized it must be sold because there may be no further growth.

In the real world, selling means paying taxes. Owning a stake that appreciates in value every year triggers a taxable event only when that interest is sold. That could be years or never. This is what makes growth investing more tax efficient and usually far superior for individual investors. The longer that an ownership interest is growing and compounding, the more effective it is a creator of wealth.

Even in accounts, such as pension accounts that are not subject to annual taxation, it is also difficult to beat the annual regularity of a successful growth portfolio. One has to find a new set of hidden values that can be realized or sold every year. Turnover in a value portfolio has to be higher than in a growth portfolio, and every change introduces additional risks.

That is not say that there isn’t a place for this type of value investing. As much as anyone, we love to find these opportunities. However, we prefer only to only sprinkle them into a growth portfolio. Also, we prefer those values that can be brought to fore by better management, and usually only buy into such a situation after a new management team, one that we believe in, has been put into place. That way we can have our cake and eat it too, because if the new team is successful, we may have a growing asset and not have to sell any time soon.

If you prefer working with a firm that understands why it invests the way it does, is disciplined, and has demonstrated success, Talk with Us.

Large Cap Stocks (S&P 500) -13.04

Dow Jones Industrial Average -7.10

Mid Cap Stocks (S&P 400) -1.64

NASDAQ Composite -21.05

Small Cap Stocks (Russell 2000) +1.03

MSCI EAFE -22.61

Lehman Corp. Bond Index 11.45

Inflation 1.9%

(Equity indices are twelve-month returns excluding dividends)