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Quarterly Letter to Clients

October, 2000

Indices at quarter-end (September 29, 2000):

Dow Jones Industrials: 10,650.92 3rd Q'00 +1.94% YTD: -7.36%

Standard & Poor's 500: 1,436.51 3rd Q'00 -1.24% YTD: -2.14%

After a nice little rally from August into early September, the market swiftly gave back almost all of its gains. The reason? Rising oil prices and earnings warnings from a number of large companies, notably some major tech and telco organizations. All of the major averages remain in negative territory for the year-to-date.

And who would have guessed that the summer rally was going to be centered in utilities? Certainly not me. It would seem that utility company margins should be squeezed. After all, the fuel that generates electricity is most often oil, at least in the U. S. It turns out that the action is in those companies that are moving to provide broadband internet connection.

A friend keeps saying, "once everyone turns on their heat this winter they'll realize the impact of oil (and gas) prices." Don't be surprised to see your electric bill higher, too. We've already become acutely aware of the price of gasoline at the pump. Factor in the attendant increases in the cost of things like shipping, and all of the raw materials that derive from petroleum, and you can easily see why corporations and analysts are predicting lower earnings.

Well, at least this situation would appear to preclude any interest-rate boosts.

Another factor depressing stock prices is the worsening outlook for the major internationals due to the decline of the Euro. Any company selling goods or services in Europe and translating this business back into dollars is feeling the pinch. These companies may hedge against currency fluctuations, but inevitably they are squeezed anyway.

The bottom line here is a softening of the per-share income of many companies, and a cloudy outlook for at least the near-term. Thus we can expect lower P-E's, and by extrapolation, lower stock prices. In a year that most have found to be difficult this may prove to be the unkindest cut. Many people have grown inured to PE's of 40 or 50 or more, believing this ratio to be irrelevant. They are quickly learning that when these companies disappoint their stock prices contract instantly, even among the anointed.

And it is just those hallowed technology issues that have led the way down. Some recent and highly visible examples: Intel, Microsoft, Motorola, Lucent, Lexmark, Apple, Priceline, Qualcomm, Yahoo, CMGI, Amazon, Dell and Oracle.

For this year as a whole, it's been a pretty tough market. And there's still the election.

When earnings expand, PE's generally expand. Greed prevails. People are euphoric and willing to pay a higher price for what they perceive to be growth. Conversely, when earnings contract, PE's shrink. Fear enters the hearts of investors and they become reluctant to commit their funds to stocks. Thus are market moves magnified. It is this effect that causes the stock market to classically move too far on the upside and too far on the downside.

It is my opinion that the good times of the last few years are now over, and we can expect the sort of stock market where you have to fight hard to realize two points over bond yields. We may very well be entering the fear phase.

Times are still good. Business is still fairly robust. People are not yet being thrown out of work, factories are not being shuttered, and oil prices seem to have ameliorated. It would be premature to predict a significant slowing of the economy. But a softening is clearly upon us, and it is being reflected in the prices of the stocks of even our premier companies. It is not a time to speculate. It is time for extra caution, a time to become conservative, to pay close attention to the valuations of our investments.

Jim Pappas