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Quarterly Letter to Clients

October, 2001

Indices at quarter-end (September 30, 2001):

Dow Jones Industrials: 8,847.56 3rd Q'01 -15.76% YTD: -17.98%

Standard & Poor's 500: 1,040.94 3rd Q'01 -14.98% YTD: -21.16%

The tragic events of September 11 seem to demand comment. But I am at a loss as to what to say that has not already been said many times over. I offer my prayers to the victims and to their families.

I will not speculate on the motives and methods of the attack, or our response. I will, however, comment on the effect of the attack on our markets.

Wall Street never needs much in the way of a reason to sell off, and this event certainly gave ample cause. Stocks were pummeled, giving up 15% on the Dow and almost 16% on the S&P 500 for the quarter. The NASDAQ is down by more than 39% so far this year, and that is on the heels of a decline of 40% the year before. Bonds were the haven, as money sought safety.

The press has made much of the fact that the week following the attack was the steepest decline since the Great Depression.

To put this into perspective, the 1973-74 drop totaled 45% over about 18 months. As I write this, the Dow is off 23% over the last 21 months, the S&P is down 31%, and the NASDAQ has lost about 67%. To look further for parallels, the eighteen months of decline in 1973-74 carried the market to lows it had not seen for 10 years. An equivalent move today would push the Dow to the low 3000’s and the S&P to 400, levels 60-70% lower than we stand today.

No one, including me, is projecting such a drop, but I hold that view only in the absence of further (and unforeseen) activities by terrorists or military action. I am groping for historical comparisons and find that I have nothing in my 35-year market experience that directly compares.

“When profits went up,” Dilbert notes sardonically, “it was great management, but when profits go down, it’s the lousy economy.” Or in this case, suicidal religious or political fanatics. Profit is what ultimately drives the markets. And when it comes to profits, Wall Street has always rewarded consistency.

In the second quarter of 2001, as I have mentioned in my last letter, the net income of America’s largest firms fell by something in the neighborhood of 65%. The third and fourth quarters, soon to be reported, promise to be equally dismal.

This sounds catastrophic, but I would like to point out a salient fact: when companies cannot avoid showing poor earnings, they often will “clean out the basement”, throwing every lingering write-off they can find into the current report. In light of recent events, my guess is that American corporations will find this to be a very opportune time to take such action.

With the markets at these low levels, and with the threat of violence still rampant, companies will most likely be forgiven poor reports over the next three or four quarters. (By “forgiven” I mean that their stocks will not be punished much more than they already have been.) Thus, I will not view the upcoming reports with quite as much negativity as some.

By this time next year it is my expectation that earnings comparisons will start to look better. If there is no further pressure on the markets from military or terrorist activity we can reasonably expect an upturn in the economy and the stock market by mid- to late-2002. With stocks at their current beaten-down levels, it would not be much of a stretch to view this as a buying opportunity.

I am currently advising equity investors who have held cash on the sidelines to invest 25-30% now, and to repeat that action each time the market drops by an additional 20-25%. I am further advising investors to assess what percentage of their assets they are comfortable investing in stocks versus bonds.

I have never seen a time when the horizon was so obscured.

Jim Pappas