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Quarterly Letter to Clients

January, 2002

Indices at quarter-end (December 31, 2001):

Dow Jones Industrials: 10,021.50    4th Q'01   +13.27%    YTD: -7.10%

Standard & Poor's 500:  1,148.08    4th Q'01   +10.29%   YTD:  -13.04%


Thus ends another difficult year for stocks.  The Dow Jones Industrials fell 7.10% for the year, the S&P 500 gave up 13.04% and the NASDAQ lost 21.05%.  For each of these averages it was the second negative year in a row.  It has been a year of contrasts.

We can’t blame it on the Fed, which has been most cooperative, cutting interest rates an unprecedented eleven times in one calendar year.  This latest cut brought the Fed-funds rate to 1.75%, the lowest level for inter-bank lending in 40 years.  Just at the beginning of the year this rate was 6.5%.  The discount rate, the rate at which the Federal Reserve lends to banks, now stands at 1.25%.  Needless to say, bonds have been strong.

The Fed’s action was taken in the face of growing unemployment and a shrinking economy.  In the 3rd quarter the U.S. economy shriveled, clocking a minus 1.3% annual pace, and the fourth quarter was almost certainly also negative.  Two consecutive quarters of contraction is the current definition of a recession.

But things are looking up.  The military action against the terrorists in Afghanistan has gone much better than I had envisioned at it’s outset.  The war created uncertainty, and the markets abhor uncertainty.  As things clear up on the military front, we become more confident in the future, more amenable to investing in stocks and bonds.  A short, winnable war is strong tonic for a lackluster stock market.

And speaking of the stock market, hey folks, it hasn’t been all that bad.

In October of 2000 I commented that the utilities were among the top performers.  This year the utilities were the worst-hit sector, with the Dow Jones Utility Average falling 28.7% for the year.  It seems that nothing is safe.  It is easy to imagine someone getting burned in Internet stocks a couple of years ago and transferring his money into the supposed safety of utilities.

The utility weakness has largely been attributed to a single company, Enron.  And due to the Enron debacle, our whole accounting system is being called into question.  Perhaps it's about time.

What I find truly amazing is that we’ve had a bear market and a bull market in the same year.  At least according to the media.  By late November, TV’s talking heads and the financial press had ballyhooed the bounce off the September lows as a “new bull market”.

Personally, I have a hard time believing that a year that ends with negative numbers can in any way be considered a bull market.

This is not the only confusing data with which we have been blessed this quarter.  In my October letter I said that I had never seen a time when the horizon was so obscured.  That was because of the unfolding war.  Now it is difficult to see ahead because of all of the contradictory statistics.

Lately we have been given the knowledge that we’ve been in a recession for the past 6 months.  Simultaneously we are told that we’re now in a recovery.

Money supply, any way you measure it, M1, M2, M3, is up sharply.  While this is often a sign of inflation, it is certainly good for the stock market.  Conversely, producer prices (PPI) are down sharply, as are consumer prices (CPI), both deflationary indicators.

Major corporations are calling in high-coupon debt and refinancing it at much lower rates, an action that will later produce a better bottom line.  But we are also seeing a record number of defaults and a rising overall debt level. 

I would posit that while the unemployment rate is now up to 5.8%, we should remember that means that 94.2% of the population remains gainfully employed.

What are we to make of all of these conflicting signals?

Many people, including me, are looking for the economy to recover later in the year 2002.  Whether this will actually happen and whether it will translate into stock-market gains, we have no way of telling.  What I can say is that we need for companies to come through with better earnings in order to have a more ebullient stock market.

For the year 2001 we have fared much better than the averages, a fact that gives me both pleasure and comfort.  I hope to be able to continue this performance into the new year.

I wish you a Happy, Healthy and Prosperous New Year.

Jim Pappas

copyright © 2002 JPIC