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Quarterly Letter to Clients

April, 2003

Indices at quarter-end (March 31, 2003):

Dow Jones Industrials: 7,992.13 1Q'03 -4.19% YTD -4.19%

Standard & Poor's 500: 848.18 1Q'03 -3.60% YTD -3.60%

It used to be that we hung on every word that Alan Greenspan uttered. In the quarter just ended we shifted that attention to Hans Blix, then to Donald Rumsfeld. It is a sad commentary.

I hate all of the talk of war and the action of war itself. I hate the phrase “weapons of mass destruction” which our elected officials use endlessly, and which the Iraqis either do not have or are refraining from using. And I am horrified that people’s children, on both sides, must die. I do not want to discuss the subject of war in this letter or in conversation.

But I must, at least insofar as it relates to the markets. Because the war and it’s aftermath is what is on every investor’s and every trader’s mind. The effects have been felt in our equity, bond and commodity markets for months now.

For months prior to the invasion stocks declined, continuing a trend begun more than three years ago; oil and gold soared; and bonds were strong. With the actual commencement of hostility, everything reversed; stocks rocketed, oil prices tumbled, gold gave back some of its gains, and bonds were mixed at best, reflecting the rapid redeployment of money into equities.

The consensus opinion has been that if we see a quick resolution to the Iraq situation the stock market will almost certainly shoot up. For once, the consensus appears to be correct, as markets did not even wait for victory, which is a virtual certainty.

The removal of the uncertainty as to when and even if we would invade, seemed to be the fuel propelling stocks into a powerful rally, carrying the Dow Jones index a thousand points higher in two short weeks, even pushing, momentarily, into positive territory. We can expect continuing dramatic swings in the market based upon the daily news.

Whether the rally can carry is another question. What is often not voiced is the fear that the market will slip back to pre-war levels at the conclusion of the war.

The bear case relies heavily upon the uncertainty of our military action and possible terrorist retaliation; the bull case upon a quick, successful outcome. The end game will certainly depend upon domestic economic conditions following the scuffle.

We are certain to send many billions of our dollars abroad for the rebuilding of Afghanistan and Iraq. Perhaps one benefit will be a steady supply of oil at stable prices. A cost is to be seen already in our Federal deficit, which is ballooning out of control.

Many people are asking me if I think interest rates are going up, and what effect will that have on stocks and bonds. We all know that bonds will be hurt by rising rates. But if interest rates go up, what happens to stocks? The answer: stocks will go down. I must say, though, that I believe that we have entered an era that will see very low interest rates for a long period of time. I am having trouble envisioning a scenario where the government can raise rates.

The bigger question to my mind is what happens to inflation? Because war is an inflationary act: we build things to explode. This adds nothing to the economy other than the velocity of money.

I have noted above that inflation hurts both stocks and bonds, and that rising interest rates also hurt both markets. Can we have high inflation and low interest rates? I cannot recall any time in recent history when those two conditions existed concurrently, and they would seem to be mutually exclusive. I can recall, however, high inflation and a stagnant economy.

The markets, though, are emotional, driven by psychological swings, and not easily subject to rational analysis, at least in the short term. Anything can happen, and it is extremely difficult to foresee the next turn of events, now more so than usual.

There is an old saying, “May you live in interesting times.” We surely do. I wonder now if that is a blessing or a curse.

In sum, the markets hate uncertainty, and though one uncertainty has now been lifted, many others remain. I pray for as quick and bloodless a resolution as possible to the situation; I hope that our sons and daughters can return home, safe, in short order.

I believe our portfolio is in as good a position as possible given the circumstances. I do not advise any radical changes to our holdings.

Jim Pappas