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:: January 2004| Page 1 of
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Dear Clients and Friends,
Last year started out as more of the same, a weak economy
and slumping investment markets. The stock market lows of
the previous October were outdone by further declines into
March as fears surrounding the war with Iraq mounted. Following
three consecutive years of declining stock prices, the pain
became too great to bear, leading to "Just get me out!"
selling that finally established the bottom of the prolonged
bear market.
A snapback began in April and carried through to the end
of December. The major market averages closed out the year
with gains of 25-50%. The NASDAQ Composite Index, most representative
of smaller, technology issues, set the pace as stocks with
the lowest prices, no dividends, liberal accounting and little
or no earnings recorded the greatest percentage gains in what
some have termed an "echo bubble" given the similar
leadership to the 1999 to 2000 era. It is well to keep in
mind that a stock that traded at $64 in 2000, but had dropped
to $2 in 2002 gained 100% when it rose to $4 last year, not
such a terrific performance for those who purchased the stock
a few years ago. The NASDAQ Composite at 2,003 is down 60%
from its 5,048 peak in March of 2000.
After passing the point of psychological exhaustion, the
subsequent rebound in equities garnered increasing support
from signals of the long awaited, elusive second half business
recovery. The most extensive program of government stimulus
in memory began to take hold in the third quarter as real
gross domestic product climbed at a rate of 8.2%, the best
in twenty years, exceeding the most optimistic estimates.
Corporate profits surpassed $1 trillion for the first time.
Hefty incentives from auto manufacturers managed to keep unit
sales above a 17 million annual rate. Housing construction
and sales remained unusually strong thanks to the lowest mortgage
rates in decades, and the stalwart consumer refinanced his/her
house taking out cash to help maintain spending levels. As
the year progressed, employment showed little improvement
causing some to question the sustainability of the recovery.
Nonetheless, economic forecasts call for an increase in total
economic output of around 4% in 2004. It is anticipated that
business spending will pick up in response to stronger demand,
resulting in increased hiring. Earnings forecasts have been
increasing, and currently center on a gain of 10-12% for the
companies in the Standard & Poors 500.
Even though the outlook for the economy and earnings is positive,
the rise in valuations suggests caution. Investors are now
paying $17-18 for one dollar of estimated earnings of the
S&P 500. This valuation is above the long-term average
of $14-15, but is consistent with prices paid during previous
periods of very low inflation and interest rates. Although
these valuations may be reasonable, yet not cheap, most alternative
investments
are less appealing. High-grade bonds had a modest positive
return in 2003, but at current rates would return only 2-4%
if held to maturity. The Federal Reserve has kept short-term
rates unusually low to head off deflation. They are now attempting
to increase inflation to over 2% versus last month's year
over year rise in the core rate of only 1.1%. If the global
economic recovery continues, a rise in interest rates would
follow, resulting in a decline in the market price of bonds
purchased at today's historically low rates. Currently, returns
on cash reserves such as Treasury bills are negative after
inflation.
High yield ("junk") bonds had a terrific move last
year equaling the gains in the stock market, but at best,
should earn their stated interest rate this year. Their higher
risks evidenced by their low credit ratings no longer offer
sufficient reward above high quality securities. In this environment
however, individual stocks with healthy prospects can be found
at reasonable valuations. The markets react sharply to negative
news that can temporarily depress the price of a stock, presenting
an opportunity to value-oriented investors. Conversely, some
stocks have moved above their normal valuation levels, and
should be monitored closely to take profits to preserve gains.
Investor expectations are positive projecting moderate gains
for the stock market in 2004. A year ago, some market strategists
maintained optimistic forecasts for the stock market, as they
had done incorrectly for the previous three years. The consensus
of a substantial number of institutional investors however
called for a "low return world" for the next five
years in nearly every asset class. This year equity prices
are expected to move up in line with improving earnings, 10-12%.
Fundamentals are positive: low inflation; low interest rates;
low inventories; high productivity; and rising new orders.
After years of cost cutting, operating leverage should allow
a sharp increase in earnings as sales pick up. Perhaps the
biggest positive surprise of the year would be earnings that
come in well above expectations. While there are still many
concerns for investors looking toward the end of the year
and into 2005, they feel much relieved after the recent gains,
but are far less ebullient than they were a few years ago.
There is still a large amount of cash on the sidelines earning
less than 1%, including over $2 trillion in money market funds.
Foreign private investors have pulled back from investing
in the US as the dollar declined about 20% in 2003, but the
greater purchasing power of their currency makes US assets
more attractive once they believe the dollar has stabilized.
Looking ahead to evaluate opportunities for 2004, it may
be worthwhile to consider several trends which developed last
year:
One of the most significant events during the year was the
reduction in the tax rate on dividends from as high as 38%
to 15%. Corporations have begun to increase dividends significantly
as a result. It seems that investors have not fully responded
to this change, and going forward, dividend-paying stocks
should attract more buyers.
High quality companies with multinational exposure should
benefit from the decline in the US dollar. For example, a
corporation that earned one Euro in 2002 would have reported
about $1.05 of earnings on its income statement. That same
Euro would now translate to $1.25 in 2004. Although some tend
to discount the value of currency-derived earnings, the reported
numbers are still likely to influence stock prices.
China's spectacular growth as an industrial power exerted
a powerful influence on the world economy in 2003. Its production
of low cost goods helped hold down inflation, but also shut
down much US manufacturing with many jobs lost. China also
emerged as a huge consumer of energy and raw materials driving
up the price of many commodities. These trends should continue
in 2004, and could lead to pressure for increasing protectionism
in this country.
Energy prices held at elevated levels much longer than analysts
expected last year. The major companies in this sector lagged
the market even though earnings were strong. Drilling activity
was surprisingly low given the high prices, and supplies tightened
as the improving economy increased demand. The natural gas
supply in the US faces increasing shortages over the next
several years, and many companies are planning to build new
facilities to import liquefied natural gas (LNG) from overseas
where supplies are abundant. US gas producers should be operating
in a favorable environment, drillers should see increased
activity, and construction firms could see opportunities for
new LNG terminals.
Federal government spending soared as all restraint evaporated
after September 11. The enormous swing from surplus to deficit
should be a major contributor to business recovery in the
short-term, but poses problems as the economy rebounds and
fiscal stimulus is no longer needed.
In conclusion, 2003 turned out to be a rewarding year for
most investors. We remain cautiously optimistic for the months
ahead, but will be keeping a close eye on individual stock
prices to protect gains.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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