RCM July02 Perspective

Continued fallout from accounting scandals and examples of poor corporate governance have served to create investor malaise and disgust. Throw in a little insider trading, instances of excessive executive greed, and a few executive severance-packages (the size of the GDP of some small countries), and you have a recipe for an equity market collapse.

By the close of this quarter, equities were at levels not seen since the post September 11 sell-off. Until this quarter, some categories, such as small-cap and value, had bucked the downtrend. Now, they too, fully participated in the most recent sell-off. In short, there was no place for the investor to hide.

The second quarter was one of the worst we’ve seen in some time. Investors turned morose, with most news, even positive, being interpreted in the negative. This was so, even though fundamentals stayed relatively positive. To most investors, the glass appeared half-empty instead of half full. As a result, volume has been lighter than usual with many investors unwilling to participate. Markets became thinner and more subject to wild swings as hedge funds and traders tried to make something out of nothing. Rumors and innuendo proliferated, testing long-term investors' nerves.

At the end of June, another huge boulder was thrown into this pond: WorldCom revealed massive fraud in the calculation of earnings and cash flow over the past five quarters. This set up a climactic sell-off that may have given the final excuse to sell to some wavering investors. Stronger constituted investors bought what may prove to be outstanding bargains.

Whether the WorldCom news provided the final negative washout, only time will tell; but the equity markets are certainly poised for some reversal and the possibility of a more balanced outlook.

Jeremy Siegel, Ph.D. of the Wharton School has calculated that the S&P 500 index is about 16% undervalued based on the next twelve months earnings estimates. With corporate management now focused on profits, further economic recovery, and continued growth, returns over the next few years ought to be very good. Investors that have stayed the course should be well rewarded. The foundations of fortunes are often created during difficult times.

Growth in the second quarter has probably slowed to a 2 to 3% pace, after a surprising rebound in the fourth quarter of last year and a torrid 6.1% pace in the first quarter of this year. Consumer confidence has slipped. This is probably in response to the poor performance in the equity markets, but as of this writing, still remains positive.

Until recently there had been a disconnect between the real economy (which has been doing reasonably well) and the poor performing equity markets (the glass half-empty phenomenon trend mentioned earlier). This may be a part of the reason that the growth rate has slowed. It certainly seems to be a factor in the delay in a pick up in corporate spending and investment.

Even though the U.S. has had three consecutive quarters of economic growth, it has not seen one month of inventory rebuilding. In fact, the draw down has been at a record pace. The beginning of inventory rebuilding along with money supply (once again growing) may provide some re-acceleration of economic growth in the second half of this year. Hopefully investor psychology also will improve.

Normally investors anticipate change in economic conditions by three to six months. Recently it seems that economic change is ahead of the investor. Skepticism is very high.

After two years of negative returns in the equity markets, odds were that 2002 returns would be better than average. A recovering economy had been a relatively safe call. However, what has been surprising is the lack of corporate leadership and concurrent negative psychology.

Obviously, the negative psychology is a result of disgust with some corporate behavior, fears of additional terrorism with its impact on the economy, and other geo-political concerns. By now, most examples of egregious corporate behavior probably are behind us, we are learning to live with increased physical insecurity, and global tumult really is nothing new.

Earnings are the key. We anticipate some positive surprises here. The Wall Street Journal has reported that twenty-six S&P 500 companies have reported results for the second quarter as of this writing. Nineteen have exceeded expectations, two missed and five matched. Thomson/First Call expects this pattern will continue this quarter. Some of the strong productivity growth over the past two quarters should show up as increased profits. Markets do not produce returns in a smooth fashion, but in surprising and very uneven jumps. We still believe good returns are coming.

The slowing recovery in the second quarter means continued low interest rates. It is unlikely that the Fed will raise its targets for short-term rates until it is confident of a sustained economic recovery. That point in time has been moved out. If we are correct that the economy will reaccelerate in the second half, then interest rates will begin rising toward the end of the year or early next year.

We continue investing for an economic recovery. Our selections are leveraged to economic growth. The majority of our equity holdings are world class companies with excellent market positions. Our sector weightings essentially remain the same as last quarter.

However, to provide some protection and allow for flexibility in reallocating assets to rebounding sectors, Riverplace Capital has done some selling. We took profits in some partial positions and removed three entire positions that have not maintained the fundamentals necessary for a sustained recovery.

We will reallocate funds from these sales opportunistically from RCM’s “watch list” candidates.

Recognizing the potential for a backup in rates with a stronger economy, we continue to maintain a cautious policy toward fixed income commitments. New commitments are made to short time frames and up to twenty-five percent of fixed income portfolios may be kept in money market funds.

Maintaining interest rates at levels too low could ignite inflation next year. We understand the narrow path the Fed is walking. On one hand there has been a robust consumer economy while on the other hand cautious corporate spending and the reeling equity market could drag down the real economy.

The recent rise in gold prices and corporations clamoring for better pricing suggest that inflation concerns should not be dismissed.

Greed and fear are the two faces of markets. One is the opposite of the other. Two years ago, equity markets experienced a crescendo of greed. The Dow hit a high of 11,723, the S&P 500 1527, and the NASDAQ an astounding 5048. At the recent low, the Dow was down 22% from its peak, the S&P 500 36%, and the NASDAQ 72%. The Dow only modestly participated in the bull market of the late nineties so consequently hasn’t suffered as much of a retrenchment. The NASDAQ on the other hand was the center of that bull market and suffered the worst decline.

Two years ago investors went home every night and calculated their net worth. Today some investors are reluctant to even open their monthly statements. Both extremes are unhealthy and usually signal that the trend that brought us to such a point may be close to changing.

After this manic-depressive swing in psychology, markets will find a way back to some balance. A company’s individual results should be more important in coming months in establishing valuations. Management will have to produce results the old fashion way, with real unit volume growth, respectable margins, and realistic plans.

Forget creative accounting or financial engineering. The markets will sniff examples of these out and punishment will be swift. Even allegations of impropriety will hurt (think Martha Stewart Omnimedia). If it looks fishy, investors will sell. Harsh, but probably realistic after the experience of the past two years.

That is not to say there are no growth opportunities. Actually there may be more opportunities than ever; they will just need to be real, not fictitious. Sober analysis is likely to review every result and every seeming opportunity. Exuberance, if not entirely absent from the market, is likely to be well contained.

Growth investing is likely to make a resurgence. Indeed, if market returns return to lower long-term averages over the next few years, then growth becomes more valuable and is sought out. Money flowing into seemingly safe havens (value stocks) have pushed up many valuations to a point that they no longer make sense. After all, once market participants have scrutinized everything, the only reason for increasing future valuations is sustained profit growth.

Index and sector investing may not yield very good results. Each individual selection counts. Balance will still be important to control risk, but individual corporate performance will be needed to drive returns.

Investing will be more difficult. But, don’t become discouraged. It should still provide excellent returns. Real analysis, not quick reactions or hot themes, will increasingly drive the process. Real analysis is what Riverplace Capital does and offers to you. Talk with Us.

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