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January 2003 Newsletter | Print Friendly Format

Dear Clients and Friends,

GOOD RIDDANCE

As the caption above suggests, the passing of the year 2002 will not be lamented by investors. The improvement in market statistics in the fourth quarter was not sufficient to rescue a dismal year that already was well established by the end of September.

We promise not to clutter up this letter with a recital of dreary market data for the year. It is sufficient to say that one has to go back decades to find analogous time periods in which the U.S. equity markets performed as poorly. All the major market indexes were down between 15% and 30%, winding up a third consecutive down year for U.S. stocks. A losing string of that duration has been seen only three times in a hundred years, most recently in 1939-'41, as war clouds were gathering in Europe. Equity markets elsewhere in the world also suffered significant declines last year, leaving all stock investors licking their wounds. Worth noting is the fact that all major S&P sectors were in deficit territory for the year.

Bondholders fared a good deal better, helped by the actions of the Federal Reserve Open Market Committee in reducing interest rates and by a significant flow of funds from stocks to bonds. Over the years, we have had a strong preference for owning some bonds in all individual portfolios, and that proclivity was very helpful in containing the effects of the bear market last year.

ANATOMY OF A BEAR MARKET

We have been close observers of the U.S. stock market for an amount of time approaching forty years. During that time period, we have seen a number of difficult environments for equities and two major bear markets: 1973-'74 and 2000-'02. In the interval prior to our tenure in the business, one had to go back to the period following the stock market crash of 1929 to find a similar, epic decline in stock prices.

Reflecting back on the two postwar bear markets prompts us to offer several observations:

[1] Market declines of this severity are rare in U.S. history and typically set the stage for very satisfying subsequent returns. We can think of no good reason why this pattern will not be repeated this time around, as we explain later in this letter.

[2] Bear markets tend to follow exuberant bull markets, typically characterized by investor fascination with some sub sector of the market, to the exclusion of all other areas.

In 1972, before the market collapsed, the Nifty Fifty stocks were the "must own" investments, while technology and telecommunications stocks occupied this hallowed ground recently. Other stocks typically are viewed with disdain, and investors suspend traditional valuation parameters for the favored group. If one is unwilling to buy these stocks, either because expectations appear to be out of whack or because the stocks just seem to be too expensive, one's judgment is called into question. In 1973-'74, those who were skeptical of the Nifty Fifty stocks were told they were taking career risk by not getting on board. The onus of arguing why one should buy stocks other than the favorites was placed firmly on the shoulders of the recalcitrant skeptics. More recently, when the Internet mania was roaring through the market, those who expressed doubt about business models that offered no hope of ever making money were told they do not "get it." Invariably, the statement is made that " it is different this time" or that "it is a new ball game."

Radical divergences of opinion at market extremes are normal, and market reversals are essential to reconciling such opposing views. When a favored group of stocks ends up disappointing investors, the resulting sense of betrayal felt by the holders becomes part of the mix that creates a bear market bottom.

[3] At market turns, whether at bull market tops or at bear market bottoms, risk perceptions are distorted.

At the top, greed overwhelms risk sensibilities, and analysis and judgment are pushed aside by investors in order to get in. At the bottom, fear trumps a thoughtful evaluation of risk, and the suitability of owning equities is questioned, so stocks get dumped. Again, this is part of a normal market cycle, and the challenge is to decide where one is in terms of the ebb and flow of risk assessment.

It is important to understand that risk is very difficult to assess prospectively. Judging risk going forward requires a careful evaluation of what is happening in the market and what expectations of the broad sweep of investors may be. This is not an activity that leads to a conclusion that can be stated precisely and defended with hard information. For that important reason, the investment manager who cautions against the excesses in the market is at a major disadvantage, because he or she is grappling with an intangible uncertainty.

By contrast, gauging risk retrospectively is pretty easy and can be done simply by measuring the damage that has been inflicted by the strategies employed. In a subtle way, the process of damage assessment can be very helpful in identifying market bottoms because of the widely held feeling of dispirited investors who want to "get out" to "keep what I have left." In an interesting way, the investor at a market top looks outward at how much money his friends are making, prompting more risk taking, while he looks inward at a market bottom and acts to contain risk.

[4] Bull market tops and bear market bottoms are not announced when they occur. Bull markets develop and peak at times when the outlook typically is without blemishes and terminate without any obvious reason, although explanations are plentiful during the post mortem phase. Bear markets evolve and bottom when prospects are grim. Unfortunately, at neither junction is there a clear signal to identify the turn in fortunes.

Economists and market prognosticators alike saw not a cloud on the horizon for either the economy or the stock market in early 2000 as the averages were setting highs. Up to that point, economic growth prospects, buoyed by the "productivity miracle," seemed boundless and open-ended, and companies such as Cisco were thought to have the potential by themselves in due course to rival the size of the U.S. economy. The market value of the stock exceeded the combined gross national product of several major economies in Europe.

By contrast, these same folks now are gnawing their nails about the recovery path for the U.S. economy, and there is little or no conviction about the outlook for corporate profits and equity prices. We need to remind ourselves that the economy always comes out of slowdown or recession with an acceleration of growth. In turn, faster economic expansion creates an environment in which companies will report earnings improvement that can be startling because of the benefits of cost cutting during the lean period. It will be thus again in this cycle, so it makes sense to invest on the basis of the way the world will look a year or two from now.

[5] Bear markets gain momentum as a result of declining investor confidence, and some sort of a crisis environment provides the context for a market bottom.

In 1974, citizens were parked in lines at the gas pump to refuel their cars in the first oil crisis; they realized there was a scoundrel in the White House; inflation and interest rates were high; the Mideast was embroiled in war; and stock prices had plummeted by almost 50% over two years.

In 2002, the global economy was in a broad slowdown; oil prices had jumped sharply in response to the potential for war and in the face of unrest in the world of oil suppliers; this country was engaged in a no-hold-barred campaign against terrorism; it became clear that corporate executives, accountants, investment bankers and others had been engaged in activities that were in conflict with the interests of shareholders; another war in the Mideast seemed inevitable against the backdrop of an already undeclared war in Israel and Palestine; and the stock market at one point was down almost 50% from its high in March 2000.

The similarities between these time frames abound, but the most important point to be made is that bear markets require significant erosion of confidence and growing risk aversion. For that reason, such markets tend to bottom in an environment of a crisis in confidence and acute levels of risk sensitivity.

When we wrote you last Fall, we felt the ingredients for a market bottom were present by the end of the third quarter. In addition to noting a gloomy mood on the part of investors, we expressed the opinion that the economy was beginning to turn, because a variety of economic time series were beginning to be mixed, rather than being predominantly negative. Further, mundane companies here and there were reporting earnings that were somewhat better than expected as a result of aggressive cost-cutting actions undertaken by managements in response to prospects that seemed poor.

Our opinion on the outlook for the economy and the market has not changed. We recognize that the geopolitical arena, especially the prospect of war with Iraq and the unstable situations in North Korea and Venezuela, contribute to the level of risk, but this is not new information and likely is reflected in stock prices.

As a further risk ingredient, the U.S. dollar looks increasingly feeble, but the "flight to quality" predilection that surfaces during times of international crisis could cause the pattern of weakness to be reversed if hostilities start. In addition, a softer dollar would help to reduce our trade deficit and would benefit U.S. corporations as they report foreign-sourced earnings, providing some offset to the risks associated with currency flows as investors avoid a declining currency.

Admittedly, the outlook seems decidedly mixed, in some respects even dreary, but that is typical of the environment that normally accompanies market bottoms. We are constitutionally unable to be rampantly bullish and we think high levels of volatility will continue to be part of the mix, but we think the odds favor a solid year in equity returns in 2003.

On another topic, we are pleased to announce that the merger of Trust Company of Maine into Acadia Trust was completed on January 1 of this year. Most of our readers are aware that Camden National Corporation, our parent company, also owned Trust Company of Maine, a state-regulated, non-depository trust company located in Bangor, Maine. The two entities have been collaborating closely for more than a year, and we are delighted to be united under a single corporate banner. We will continue to maintain offices in both Portland and Bangor.

With the combination of the entities, we offer a full range of investment management, trust administration, retirement plan administration and custody services.

Sincerely,

Johann H. Gouws, CFA
President