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Quarterly Letter to Clients

January, 2003

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

Dow Jones Industrials: 8,341.63 4th Q'02 +9.87% YTD: -16.76%

Standard & Poor's 500: 879.82 4th Q'02 +7.92% YTD: -23.37%

The market hit bottom early in November, and has mounted a very nice rebound since. But the bounce was not nearly enough to reverse a negative year. All of the major stock indices were down, for a rare third year in a row. Bonds, which performed so very well in 2000 and 2001, were once again the best place to be.

The year saw several of the biggest bankruptcies of all time, including Worldcom, Conseco, UAL, and Kmart. In terms of major-company bankruptcy filings, it was the worst year that I can remember, and certainly one of the worst years on record. Investors learned the very difficult lesson that corporate management cannot always be trusted.

Thus, today market sentiment resides at the depths: a wealth that never really existed has faded into memory and today’s general feeling is fear, distrust of the future, and a nagging worry that the center will not hold, that the economy is a house of cards in a rising wind.

Only three short years ago the mood was one of euphoria: the economy, and the stock market in its wake, seemingly had an infinitely bright future. Everyone was going to retire early and live comfortably amidst a world of eternal prosperity, awash in consumer goods.

Now, I am a realist. I know that anything can happen, and, when we least expect it, will. I have survived in this business by constantly being worried. And I have many worries now.

One of my fears is an interest-rate scenario that mirrors Japan’s, where extraordinarily low rates have prevailed for many years. I note that Japan’s economy and stock market have not exactly been bolstered by that country’s low rates.

For thirty years, from roughly 1930 to 1960, stocks yielded more than bonds in the U.S. For the last 40 years now the opposite has been the case. I worry (albeit remotely) that could happen again, brought about by government action, or by a general flight to safety, exacerbated by companies raising their dividends in an effort to attract buyers to their stock.

A more real fear is stagflation, a condition last seen the 1970’s. It’s symptoms are slow (or no) growth accompanied by inflation. Businesses find it difficult to raise prices, even as their cost of production is going up. We certainly have the slow-or-no growth part of the equation. It is easy to imagine oil prices or war pushing inflation upon us.

The Fed has pushed interest rates to a very low level, and has flooded the economy with cash, all with the intended purpose of igniting growth. And all, it seems, to no avail. One of my fears is that government intervention will fail to get the economy going again.

I fear war, the disruption of oil supplies, terrorism and El Niño. I wonder why gold keeps going up and the dollar keeps going down.

And yet statistics are on the side of a higher stock market in 2003. The last time the markets were negative three years in a row was the 1939-1941 period, which, of course, was the onset of World War Two. To find a four-year consecutive decline (an event that has happened only once in the last 100 years) you have to go back to 1929-1932.

One of the commentators on TV on New Year’s Eve said that the lower the market goes the easier it will be for it to show gains in 2003. Well, yes, the lower the price the lower the risk, and the greater the likelihood that it will move higher. Let’s hope.

While we know now that yesterday’s euphoria was unwarranted, I believe that today’s pessimism is equally unfounded. Yes, business is sluggish and may continue to be; real estate prices are likely to come down out of the stratosphere; and war looms. Stock prices reflect these factors.

But when, exactly, do you really want to be a buyer of financial instruments? At the top, when exuberance rules and prices are at their highs? No; you really want to buy when the outlook is the bleakest, for it is then that prices are lowest, and risk minimal. Recognizing that point is no mean feat. Acting upon that recognition is even more difficult.

For the year just ended we have once again done better than the market overall. Prudence again dictates a cautious approach, via a balance of quality equities, bonds and cash. In the new year I will continue to do my utmost to protect and preserve your capital.

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

Jim Pappas