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Quarterly Letter to Clients

April, 2002

Indices at quarter-end (March 31, 2002):

Dow Jones Industrials: 10,403.94 1Q'02 +3.82% YTD +3.82%

Standard & Poor's 500: 1,147.39 1Q'02 -0.06% YTD -0.06%

Enron and Arthur Andersen have taught us that where there’s smoke there may also be mirrors. This accounting scandal may very well turn out to be like asbestos; a problem that never goes away, that keeps cropping up at the most unexpected and inconvenient times.

Perhaps, though, the manufacturing sector will get a boost from all of the accountants buying new shredders.

And now we know how we can have a tax cut and a balanced budget at the same time; simply by using Arthur Andersen to do the books.

While there are a million one-liners, that’s enough for now. Enron was a case of fraud, and in my opinion, while there may well be a number of companies pushing the accounting envelope, I do not believe it likely that there is any large number perpetuating fraud. I do expect that many companies and accountants will become squeaky-clean, at least until this matter quiets down.

Arthur Andersen, it seems, will pay the price. The giant accounting firm is under fire, losing clients at a rapid rate, and battling regulators and the courts. It is questionable whether the firm will survive, and the prospective liability seems to be keeping potential buyers away. While I feel for the Andersen employees, they seem to be blaming the Department of Justice, when they should be blaming Andersen's top brass. It is situations like this that keep the world on the straight and narrow.

March came in like a lamb, weather-wise, but in the stock market March arrived in the guise of a bull, with a strong advance across the board. It was a breath of fresh air for a stock market that has been somnolent for more than two years.

Towards the end of the month (and the quarter), the market leveled off, but it did not give back any substantial part of its recent gains. So, while the move was small, stock investors should be feeling better than they have for awhile. Let’s hope it lasts.

If we accept the inverse of interest rates as a starting point from which we calculate price-earnings ratios, then given the prevailing 5- to 10- year rates, that formula would seem to justify P/E’s in the range of 20-25, which is just about where we are.

But there are other factors to be considered. Earnings must arrive to support the multiples; inflation must remain docile; interest rates must stay low; peace must prevail. Any one of these items can influence stock and bond prices, and there are myriad additional factors to be considered.

Currently, the most likely fly in the ointment appears to be interest rates, which now seem to be pressing higher. While that influence is not weighing too heavily as yet, everyone in the game is aware that the most likely direction of interest rates is up. That would push bond prices down, and at the same time limit stock prices, absent earnings growth.

The market's reaction to any Fed move to raise rates will depend upon just how the Fed handles such a move. If done properly, i.e., slowly and in response to (supporting) economic data, stocks are likely to largely ignore any boost. And if the perception remains that inflation is under control, then the reaction of the bond market should be ameliorated. The Fed has "oversteered" for the last two years, and it is important that they start to get it right.

Lately we have also felt a sharp jump in gasoline prices, and this tends to have a very broad effect on the economy, both inflationary and dampening.

Thus, two important factors are poised to negatively affect the markets.

However, I have been in this business for a very long time, and I have learned to roll with the punches. Mine is a long-term strategy. I will accept this very nice rally, and while I know that we will doubtless have offsetting declines, I will feel good for the moment. There will be plenty of time to worry later, and always something new to worry about. Worrying is my job, and one of the things I do best. Hold the course.

Jim Pappas