How’s your heart? "Not for the faint of heart" may be an understatement. In our January Perspectives, we made this prediction and forecasted a volatile year in the equity markets. Even we are amazed at the magnitude of the moves, their velocity and the subsequent reversals.

The first quarter ended as another "tech wreck" was getting under way. The "wreck" turned out to be a 187 car crash on the information super-highway. In early April, the NASDAQ was up 25% for the year after posting an 85% return in 1999. By late May this index was down 22%. Instead of a correction, some financial commentators referred to this as a "bear market."

To be more accurate, the damage was most prevalent in the technology sector. Financial, drug, and consumer staple stocks were recovering from very depressed levels. These groups were showing good year-to-date returns throughout this period. We now see the broadening in the markets we forecasted in January.

April and May started the process of determining which companies of the "new economy" have a future and which do not. The initial stages of this process are always messy with fear the over-riding impulse. Later, there is greater investor discrimination among individual companies and their prospects.

We found out how "broad and dramatic this correction turned out to be". Several hedge funds and many small-time day traders were eliminated from the scene. It was brutal, but at least quick.

In June, the higher quality technology stocks recovered. In the meantime financials, which had been recovering, took a steep decline after a profit warning by an old stalwart, Wachovia. The retail and capital goods sectors also went into a decline as consumer staples began recovering. Oils along with health care did well throughout this period. This pattern of rapid group rotations is now the norm in the equity markets. Trends do not last long. Leadership is weak. Sectors take turns correcting then recovering. The equity market is lurching from one economic indicator or news event to another.

After a good rally in the fixed income markets during the first quarter, bonds corrected again in April. This correction started after a CPI report indicated an acceleration of inflation in March. At the May meeting of the Federal Reserve Open Market Committee, short-term rates were raised ½%.

By June, many indicators were showing obvious signs of economic slowing. At this point, the bond markets began rallying again. June CPI and PPI reports showed better inflation numbers for May. Although inflation has picked up modestly the rate of increase is still low. At the June "Fed" meeting, the board of governors left rates unchanged.

The economy is slowing. Other indicators have reinforced those of a slowing economy, as mentioned in the last Perspectives. These include slowing retail sales, falling industrial production, weaker employment growth, and surveys such as those by the National Association of Purchasing Managers.

The most recent interest rate hikes will accelerate this trend. Again, there are plenty of reasons to anticipate a soft landing. The economies of our major trading partners are in upswings. Our economy is much more diversified than years ago, with many sectors insensitive to interest rates. Corporations seem to be increasing their capital spending in order to stay competitive. Corporate profitability is high and projected to grow about 15%.

In short, we do not see a recession anytime soon. However, there are two variables, either of which could force a reassessment of this opinion. The first is an over-tightening of interest rates by the Federal Reserve. The second is a major tax cut by a new administration applying new fiscal stimulus, which would frighten the bond market into even higher interest rates.

There has been a move from "growth-at-any-price" to "value-means-something". The equity markets have broadened with more and more sectors participating in rallies. Last year was mostly a "tech" show. This year we are getting good returns from consumer staples, health care, oils, financials, and utilities. Also, within sectors, the market is much more discriminating among individual companies. In the January Perspectives, we predicted good potential from most sectors expect technology. So far, this seems to be accurate. Selected technology stocks are still doing well, but selected is the operative word. Many new companies in this sector are down for the count.

Quality is all-important this year for companies in each sector. This should continue to be the case, as the markets sort out what kind of economic environment we will have as a result of the Fed tightening. We continue to expect good returns from our equity holdings reflecting the growth in earnings.

We believe interest rates have more to fall. We realized that volatility would affect fixed income as it has equity markets, but that the inevitable slowing of the economy would be favorable. This is now happening.

Treasury interest rates responded first to the softening in the economic growth rate. Municipal bond rates are lagging but should follow. Corporate rates will come down cautiously as market participants determine if economic slowing will affect the credit worthiness of issuers. With our economic soft landing expectation, we believe we will see excellent performance from the corporate sector as well. Returns from our fixed income holding should be good this year.

We are maintaining a balanced approach to sector weightings. No big sector bets are being made. We are slightly underweight in basic materials and technology, and modestly overweight in consumer staples and financials. All other sectors are close to their S&P weightings. We anticipate no real change from this posture over the next two quarters.

Our holdings are of very high quality and we are satisfied with their corporate performance. We currently have no stocks on our problem list.

As interest rates rose last year, we slightly extended our average-life and duration targets from 5-7 to 6-8 years. We are holding at this level, but as rates fall in the future, our next move will probably be to move back to 5-7 years as a target.

We only buy high-quality debt instruments with credit ratings of "A" or better. Corporates and municipals are trading at significant discounts, compared to treasuries, and offer good value. Our preference is to buy in these two categories where appropriate.

A few days ago a friend of mine called me with a question that put into interesting perspective the changes in the financial market since I entered it over twenty years ago. As she was dressing for work, with one ear on the morning financial news, she overheard a commentator off-handedly refer to "blue chip tech stocks." My friend, who fancies herself a wordsmith, said this term perplexed her mightily. She asked, "You’re the expert. What can this mean?"

Before I had the chance to answer her, she pointed out that this single piece of jargon was fraught with contradictory meaning. For years, blue chip has connoted solid (if not stolid) investments in companies that produce basics, and to her conjured up images of investors living in old main-line neighborhoods, safely living off periodic (if not stellar) dividends. Tech stocks, on the other hand, always had meant to her those mystifying and novel investments of the last ten years that had made Seattle twenty-somethings inconceivably rich, producing items my friend frankly confesses she doesn’t understand.

How then, she asked, can there be blue chip tech stocks?

Her point is well taken. The juxtaposition of these two terms tells us a lot about the speed with which the current market operates. It tells us that the economy moves with lightening speed—that the market deems that companies in existence for only fifteen years can be accorded a title that took older ones generations to achieve. It also tells us that tech stocks have been accorded a status and role within the investment landscape unforeseen not long ago.

The question is, which tech stocks should be accorded the mantle of blue chip?

This quarter we’re seeing the annihilation, in some circumstances, of Internet companies that could not make the grade. We are seeing the sheer folly of those companies, so beloved, just a few short quarters ago, of venture capitalists and day traders everywhere, Do you remember when anecdotal philosophy was that any investment in the Internet was considered a sure thing? (Remember all those Internet ads during the Super Bowl that supposedly promoted Internet services that no one understood?)

We all know that the initial fortunes have been made. What is less certain, though, is what the second and third waves of economic changed occasioned by the Internet revolution will bring. If the economic terrain for Internet entrepreneurs is riskier than before, then the investment landscape in this sector is laden with greater challenges as well.

At Riverplace Capital, of course, we didn’t follow the anecdotal philosophy. Anecdotes and quick unproven trends are not our style—and never will be. It’s our task, and that of all management companies in the twenty-first century, to avoid hype (and it’s mighty, these days). Our task is that which it has always been: to research, evaluate, and prudently invest in those technology companies that have what it takes—sound products and services, excellent management, and long lasting potential. These investment basics may be harder to define in the technology sector, but they remain paramount. To get the benefit our discipline and experience, Talk With Us !

Large Cap Stocks (S&P 500)

Dow Jones Industrial Average

Mid Cap Stocks (S&P 400)

NASDAQ Composite

Small Cap Stocks (Russell 2000)

MSCI EAFE

Lehman Corp. Bond Index

(Equity indices are six-month returns excluding dividends)