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As of December 11, 2002
Index	YTD % Change	Market Value
Dow Jones Industrials	-14.3	8,589.14
S&P 500	-21.2	904.96
Nasdaq Composite	-28.4	1,396.59

The most significant changes from our last Outlook, aside from an eight week recovery of the market after six straight monthly declines, have been the Federal Reserve Board’s reduction of interest rates by 50 basis points which we indicated would likely occur if the economic data came in weaker than expected, and the Bush administration’s strong interest in an economic stimulus package that includes the elimination of the double taxation of corporate dividends. It is a move that the White House hopes will boost both the U.S. economy and the stock market. Economists have long argued that dividends are taxed twice. Companies pay dividends from the earnings left after paying corporate taxes, and then shareholders pay income taxes on the dividends they receive. However, corporate interest payments are deducted from income before taxes. This unequal treatment has encouraged companies to take on debt, which has tended to weaken their balance sheets.
Individual holders of common stocks, especially those in higher tax brackets, have generally preferred capital gains to cash dividends. Investors can keep a larger portion of their profits from realized capital gains after taxes than they are allowed to keep from interest and dividend income. Because of the unequal tax treatment of interest and dividends, growth stocks have tended to be popular and generally overpriced relative to high-yielding dividend paying stocks.
Over the years, corporations have focused less on dividend payouts and more on boosting earnings per share. The pressure to show regular double-digit earnings growth to drive stock prices higher contributed to the recent corporate accounting scandals. For quite some time business groups and common stock shareholders have been pushing for a change in federal tax policy towards dividends.
To end the double taxation of dividends, the administration could eliminate either the corporate or the individual tax. We believe that the President prefers eliminating the tax at the individual level. The individual tax option is cheaper since about one-half of dividend recipients are taxed-exempt entities, such as foundations, pension funds, and IRA accounts. A new tax break would not be beneficial to taxed-exempt entities and for that reason it would not lead to as great a reduction in federal tax-revenues.
Reducing the individual federal tax on dividends would make dividend-paying stocks more attractive to taxable individual investors. Corporate dividend-tax reductions to companies would increase business investment and improve balance sheets by encouraging companies to issue equity rather than debt. According to a White House study, either change should foster enough economic activity for the federal government to recoup about one-half of the tax-revenue loss.

Monetary Policy

The Federal Reserve Board’s recent decision to lower interest rates 50 basis points brings the federal funds rate down to 1.25 percent, a forty-one year low. In spite of the stimulus the Fed has provided through twelve rate reductions, the economy is not growing fast enough to prevent unemployment from rising. As can be seen in Appendix A, the Federal Reserve has been aggressively expanding the money supply to stave off the strong deflationary headwinds facing the U.S. economy.
For those concerned that the central bank has little ammunition left to lower rates further should the need arise, a November 21st speech by Federal Reserve Board Governor Ben Bernanke to the National Economic Club in Washington D.C. is noteworthy and remarkable. We quote some of his speech as follows:
“With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem–the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.”
And he goes on to say,

“So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency. A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored. For example, according to the University of Michigan survey that underlies the index of consumer sentiment, the median expected rate of inflation during the next five to ten years among those interviewed was 2.9 percent in October 2002, as compared with 2.7 percent a year earlier and 3.0 percent two years earlier–a stable record indeed.
The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.”

Governor Bernanke continues,

“To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.
The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.”

U.S. Economy

The flexibility and resilience of the U.S. economy is encouraging for the future. The Conference Board said its consumer confidence index rose to 84.1 in November from 79.6 in October. Sales of new homes continue to run at strong levels with a seasonally adjusted annual sales rate hovering around 1.7 million units. The Commerce Department reported that third-quarter inflation-adjusted gross domestic product rose at a surprisingly robust annual rate of 4.0 percent. The government also reported that the GDP, the value of the nation’s output, grew faster than initially estimated in the July-September period. These are significant pieces of evidence that the U.S. economy has stabilized and may even be on an expansion track. However the U.S. unemployment rate jumped to an eight-year high in November. The manufacturing sector lost 45,000 jobs; it was the sector’s 28th consecutive monthly decline. Despite the poor performance in the manufacturing sector there are signs that the U.S. economy is firming. Stocks and corporate bond markets have rallied and the service-sector economy strengthened in

November.

Worker productivity grew faster in the third-quarter than originally thought. Its growth over the past 12 months was the fastest pace since 1966. This is a positive signal for the country’s standard of living. Productivity is the ultimate determinant of how well Americans live. Gains in productivity enable companies to pay workers more without raising prices and the economy to grow faster without inflation. For most U.S. companies top line revenue growth has been extremely difficult to achieve. Weak revenue growth has forced companies to make the most of advanced technology in order to become more efficient and sustain their profitability. If companies remain committed to improving worker productivity, profits will improve once demand for their products and services picks up. Regrettably improving productivity for now has largely been a defensive effort to stay ahead by keeping costs down.
A subdued global economic recovery may not be far off. The European Central Bank’s (ECB) 50 basis point interest rate reduction is an attempt to strengthen one of the world’s weakest regional economies. Europe’s lack of flexibility with labor has meant that even when demand falters their companies are not able to respond by cutting wages and reducing staff. This has kept the ECB from cutting interest rates anywhere nearly as aggressively as the U.S. Federal Reserve. Asia minus Japan is on track for nearly 6 percent growth this year. Japan, the world’s second biggest economy, is still mired in a decade-long recession. While it began to crawl out of recession early this year, it slipped again in the past few months amid skepticism over the health of their banking system. China has emerged as the real engine of growth for Asia.
The challenge which faces the administration in promoting a more aggressive fiscal stimulus program in conjunction with a loose monetary policy is made more difficult by the need for state and local governments to eliminate their deficits which could total in excess of $80 billion and which will subtract from any federal government stimulus ultimately approved by Congress. The economic risk in the United States is that consumer spending weakens before business spending accelerates resulting in slower growth for the U.S. economy. Since the United States consumer is the principal engine of growth for the world economy, any stimulus will tend to increase the United States’ trade deficit, which could easily put downward pressure on the dollar and raise the perception if not the reality of increasing inflation. As can be seen in Appendix B, the current account balance is approaching $500 billion, and one could argue that this cannot go on indefinitely without resulting in a devaluation of the dollar.

Conclusion

Judging from the daily trading volumes of the exchanges, the markets seem to be dominated by institutions including a vast number of hedge funds. Their time horizons for investments tend to be short to say the least, and consequently we believe that market volatility will remain high. Companies can have wide trading ranges offering significant rates of return when purchased during periods of pronounced market weakness. There will be occasions for us to take advantage of opportunities that will be created under these circumstances.
With respect to any changes in the double taxation of dividends, at this time 30 percent of the S&P 500 companies do not pay dividends, and the yield of the S&P 500 is currently 1.7 percent. Should these tax changes occur in favor of greater dividend payouts, we would expect to see many corporations favor greater current returns to shareholders which we believe will have a positive impact on their valuations.
In our view portfolio strategy must encompass multiple scenarios since specific outcomes are a question of probabilities. Some of the areas which we believe must be part of a well-constructed portfolio include high-dividend paying securities, bonds, energy companies, defense companies, select technology companies, natural resource companies, and convertible securities. This would enable a portfolio to benefit from any of several outcomes which are not predictable.
To reach the goal of compounding rates of return in order to build capital over time, good equity selection will be critical. The overall valuation of the equity market remains expensive, but at the same time there exist some outstanding investment opportunities. The short interest on the New York Stock Exchange and the Nasdaq still remain at high levels, notwithstanding the markets’ rise since the low of October 9th.
The period from November to April is seasonally the strongest period of the year for equities, and next year is the presidential cycle year which invariably is a positive year for stock market returns. We should not assume that this coming year will be true to form. However, we believe the administration will make every effort to produce a better ‘03 than ’02 to ensure the reelection of President Bush.
We wish our readers a Healthy, Happy and Peaceful New Year!

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As of October 17, 2002
Index	YTD % Change	Market Value
Dow Jones Industrials	-17.4	8,275.04
S&P 500	-23.4	879.20
Nasdaq Composite	-34.8	1,272.29

The Relentless Bear Market

The relentless bear market of six straight down months has eliminated more than $8 trillion of market value since the decline began two-and-a-half years ago. The market is now at one of its most oversold levels ever. Investor’s Business Daily publishes a daily mutual fund index of 26 leading growth equity funds. As of yesterday, it is down 26.5% for the year and the Dow Jones Average has declined 17.4% this year. To believe that this is not likely to affect U.S. economic activity is unrealistic considering that the $8 trillion decline is almost 80% of one year’s gross domestic product.

Global Economic Weakness

Global economic growth is more dependent on the United States than at anytime during the past decade. Each economic region has lost its growth driver. Brazil, the engine of growth for Latin America, has faltered. Japan, the world’s second largest economy, continues in its deflationary mode, still unable to effectively handle its banking problems. This leaves China as the growth driver of Asia and the leading source of worldwide deflation. Moreover, Europe is no longer able to depend on Germany and France to enhance global growth prospects. On the contrary, Germany may be on the verge of a significant policy mistake as it shows signs of slipping into recession while the government considers tax increases and spending cuts to reduce its budget deficit in order to conform to the agreed fiscal discipline required by the stability and growth pact of the European Union. At the same time, European Central Bank President William Duisenberg again indicated that Euro zone interest rates should remain unchanged. On the other hand, France, to honor its election tax cutting pledges refuses to meet its obligations under this same pact. Mr. Duisenberg made clear that each government has to spur recovery by pursuing tax and labor market reforms. The European Central Bank is quite concerned that the stability and growth pact is at risk. This is occurring while German unemployment is rising, putting more pressure on the financial system.
The financial systems of all the major economies are coming under increasing stress. Credit downgrades are rising, delinquency rates are moving higher and global equity markets have been hitting new lows. To make matters worse U.S. investors have lost confidence in corporate behavior and are facing continued downward revisions of earnings for the third quarter and an uncertain outlook for the fourth quarter. Some of the issues presently weighing on the markets are:

• A war against Iraq…
• Declining consumer confidence…
• Reduced business spending…
• Pension fund rate of return assumptions that are too high ranging from 8% to 10% per annum and must be reduced. Corporations will have to take money out of profits to add to their funds, thus reducing reported earnings.
• State and local governments’ budgets moving into deficit…
• Rising mortgage delinquencies…
• Proforma earnings results being reported versus actual earnings results, which tend to put a better face on earnings reports…
• Energy prices that are too high with oil near $30 a barrel and natural gas over $4 per mcf.

Under these conditions, estimating next year’s earnings is particularly challenging. Many investors now feel that equity securities must sell at extremely attractive prices in order to cause them to be enthusiastic about buying.

The Equity Market is Oversold

The S&P 500 has declined approximately 25% for this year and almost 50% from its peak. During July, $51 billion were pulled out of mutual funds, a record amount of cash, as investors could no longer put up with such dramatic declines. Is it possible that this long, painful bear market is almost over? The technology bubble has still not fully deflated as evidenced by the heavy and costly debt burdens which continue to plague the telecom sector. In the attempt to reduce costs, telecom and related companies have been laying off employees to bring costs in line with revenues. With October being the end of the year for most mutual funds, tax selling could put additional pressure on overall market valuations. However, the equity market was so oversold, and the short-interest was so large that a significant market reversal is occurring at the present time.

Fixed Income-Credit Risk

Barrons’ confidence index, which is the ratio of the yield of the highest-grade bonds to the yield on medium grade bonds, has declined to the lowest level in many decades. Rising individual and business credit risks have affected bank and insurance equity valuations. If the corporate-bond market continues to lead the stock market down, then equity prices could come under further pressure. However the lead-time has been about two to four months which would mean that by early next year, if the corporate-bond market stabilizes, we could see the end of this phase of the stock market decline.
With investor confidence badly damaged by Wall Street’s conflicts of interest and corporate scandals, many investment strategists view the market as significantly undervalued, particularly so when based on their estimates of next year’s earnings. From our perspective we do not accept the view that next year’s earnings will be materially better than this year’s. Corporate profits continue to be at risk. Since the market will reflect bad news before it occurs, this bear phase will be over while the outlook could still appear to be difficult. At that time great values will have been created for long-term investors. Portfolio structure should encompass the following areas – energy companies, defense companies, insurance companies, high dividend-yielding quality equities, and select technology companies. Should deflationary forces persist as we expect, U.S. Treasuries Bonds should benefit as interest rates continue to decline. Investment flows into China are expected to continue as China continues to build a manufacturing powerhouse creating continuing deflationary pressures on the global economic system.

Consumer Spending

The stock market continues to take a toll on Americans’ household net worth. Economists now worry that a sustained decline in household net worth could cause consumers to sharply cut back on spending. Household net worth is a measure of total assets such as homes and retirement funds, minus liabilities such as mortgages and credit card debt. Current consumer spending, while healthy considering the soft economy, still is growing at only about half the rate it did during the late 1990’s. The negative wealth effect from the stock market has slowed consumer spending and hurt the economic recovery.

Expectations for Future Economic Growth

Expectations for future economic growth are highly uncertain as the recovery remains in question from quarter to quarter. Business demand is uneven and erratic, export demand is weak, and state and local governments are struggling financially. The Federal Reserve’s latest survey of business conditions has found significant economic weakness. The report known as the “beige book” was not weak enough to push the Federal Reserve to lower interest rates at their September 24th meeting. The Federal Reserve is hoping that once concerns over a weak stock and corporate-bond market subside, low interest rates will propel the economy back to a reasonably healthy growth pace by the end of the year. The “beige book” found residential real-estate markets and automobile sales both strong, but conditions elsewhere generally were sluggish or declining. With the job market still weak and consumer spending power being eroded by high energy prices, near-term growth in consumption depends more and more on home equity refinancing and modest growth in real income for those who are working. The latter story is mainly one of increasing productivity, which allows for higher real wages without inflation. Home equity refinancing depends on low interest rates and rising home prices.

The Federal Reserve

The consumer sector accounts for more than two thirds of the nation’s gross domestic product. September retail sales were weak; it was the third consecutive month that consumers held back on spending amid doubts about the economy and fears of a war against Iraq. These concerns do not bode well for the important holiday shopping season just ahead. We expect consumer spending to slow during the fourth quarter. Should the economic data begin to show even weaker performance, the chances would improve for the Federal Reserve to cut interest rates further. The Federal Reserve Board’s recent decision to leave interest rates unchanged reaffirms the belief that borrowing costs are low enough to keep the U.S. from falling back into recession. However the Federal Reserve is leaving the door open to a possible interest rate cut later on this year if the economy continues to show weakness.

Conclusion

The leading stock market averages have fallen to lows not seen in over five years. The markets are focused on uncertainties regarding the state of both the domestic and the international economy. The two-and-a-half year bear market has brought many equities down to price levels that should be rewarding when the economy begins to recover. The globalization of markets and low-cost foreign competition make it more important than ever to direct investment dollars to the companies with strong balance sheets, dominant market position and superb

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July 24th Market Rally

As of August 29, 2002
Index	YTD % Change	Market Value
Dow Jones Industrials	-13.5	8,670.99
S&P 500	20.1	917.80
Nasdaq Composite	-31.5	1,335.77

The stock market rally since July 24th has lifted the Dow Jones total market index from down 30% since the beginning of the year to down 20%, although the average return for the 26 leading growth mutual funds is still down 22% for the year. Major institutional investment firms shifted gears and increased asset allocations to equities as the July sell off reached near panic proportions.

Typically the dividend yields on blue-chip companies go to 6-7% at bear market lows, however with money market funds paying less than 1.5% and many equity securities yielding 3% – more than twice money market rates – stocks should attract investors. For example, El Paso Energy was a classic case of under-valuation when panicked sellers drove the shares down to a 9.5% dividend yield, and it then promptly doubled in share price once the sellers were out of the way. Bear markets produce these kinds of opportunities. At the end of this Outlook we will discuss market dynamics in a little further detail.

The New Corporate-Governance Law is a Positive for the Financial Markets

The just-passed corporate-governance and accounting-oversight law by the U.S. Congress has major consequences for executives, accountants, shareholders and regulators. The bill creates an independent audit-oversight board under the Securities and Exchange Commission, increases penalties for corporate wrongdoers and forces faster and more extensive financial disclosure. The goal of the legislation is to prevent deceptive accounting and management practices and to bring stability to the financial markets. It will now be much harder for auditors to look the other way in approving faulty corporateaccounting. The government’s new five-member oversight board will have the power to examine audit firms and discipline wrongdoing.

A provision of the corporate-governance and accounting-oversight law includes new criminal sanctions for executives that go well beyond the current Securities and Exchange Commission’s rules requiring officers to acknowledge in writing the accuracy of their corporate financial filings. Under the new law, chief executives and chief financial officers of all SEC-registered companies must attest to the accuracy of their financial filings. If they do so knowing the information is false, they will face fines of as much as $5 million and as long as 20 years in prison. This is likely to force senior executives to move quickly to ensure their financial reports are correct before signing-off on their accuracy. The SEC has already demanded that top executives at the 1000 largest U.S. companies swear that their most recent financial filings are accurate by August 14, 2002.

The push for having CEOs and chief financial officers personally attest to the accuracy of their results has come directly from the crisis of confidence in corporate responsibility amid scandals from Enron Corp., WorldCom Inc. and others. After a string of major accounting scandals knocked down several companies and undermined stock markets during the past year, the SEC mandated that CEOs would have to swear that their companies’ financial statements fairly and accurately reflect their financial condition. Federal securities regulators are carefully reviewing chief executives’ sworn statements on the accuracy of their corporations’ financial reporting. So far more than a dozen certification statements failed to conform to Securities and Exchange Commission standards. In addition many companies requested extensions for filing their certifications and quarterly reports.

Wall Street’s Analysts

The NASD, Wall Street’s main self-regulatory agency, is considering a range of allegations made against both Wall Street analysts and their firms. Charges may include securities fraud and violations of NASD rules that bar analysts from making misleading statements to investors. Analysts could face a wide assortment of sanctions, including millions of dollars in fines and other penalties, such as a suspension or a permanent ban from the securities industry. Acting as a bridge between the financial markets and investors, analysts once toiled in obscurity, writing reports on companies, making earnings forecasts and recommending which stocks to buy or sell. However, a few top analysts evolved into Wall Street’s equivalent of rock stars, earning huge bonuses and financial media hero worship. The NASD is now investigating analysts’ positive research reports on companies where strong evidence indicated from other analysts and authoritative sources that they might be in financial trouble. The recent stock market decline has led to numerous complaints from investors who lost money following the stock recommendations of former star analysts. The concerns are that those analysts’ research and investment banking roles created a conflict of interest. As a result, they were overly bullish on companies since they feared that their firms would lose banking fees if they were bearish. The NASD, along with other stock regulators, has issued a series of proposed new rules attempting to curtail analyst conflicts. The NASD’s action is sure to bring about a significant change in Wall Street’s research community. Under NASD rules an analyst or a broker must have a reasonable basis to make a recommendation to buy a stock. If the basis for the recommendation does not have a reasonable foundation, it is a violation of the rules.

The Economy

The productivity of U.S. workers declined in the second quarter, taking the shine off one of the bright spots of the economy during the past eighteen months. Meanwhile economists are sharply lowering their growth and interest-rate projections, for both this year and for 2003. The latest Labor Department productivity figures slipped to a 1.1% annual growth rate during the second quarter after an 8.6% annual growth rate in the first quarter. The slowdown came largely because the overall economy suddenly chilled, limiting the ability of companies to attain sufficient output from their workers. Companies are responding to the new economic climate by cutting employees’ overtime and the number of hours worked for the fifth straight quarter. Federal Reserve Chairman Alan Greenspan has based much of his optimism about the economic outlook on strong productivity trends. When workers turn out more goods and services with fewer resources it allows the economy to grow without producing inflation. This in turn makes it easier for the Federal Reserve to manage the U.S. economy. Over the long-term, strong productivity also helps raise household incomes.

While the latest numbers are down, many economists agreed the strong longer-term trend of productivity growth remains intact. In the eighteen months since the economy peaked in March 2001, worker productivity has increased at an average annual rate of 2.9%. That is well above the 1.8% average that followed the previous eight recessions. Mr. Greenspan believes this superior productivity performance has occurred because companies have made big investments in technology that have made them more efficient. Companies also have been aggressive in cutting costs in their efforts to drive profits from efficiency. Forecasters on average anticipate the economy to grow only 2.3% this year, and increasingly, economists expect weakness to last well into 2003. Economists expect the economy to grow by 3.2% next year, compared with an estimate of 3.6% a month earlier. Just a few months ago, many economists expected the Federal Reserve to begin raising interest rates by year-end because of an improving economy. Now most say increasing interest rates are out of the question.

Today’s Federal Reserve

Because inflation is so low, the Federal Reserve has been virtually flooding the market with money. Some weeks the money supply has grown by as much as a $2.5 trillion annual rate. With 10 year Treasuries yielding 4.2% and mortgage rates poised to fall below 6%, a massive home mortgage-refinancing boom is likely to occur, saving homeowners over $60 billion in mortgage interest expense. Increasing consumer spending and savings would follow as lower cost home equity loans and lower credit card interest rates stimulate economic activity. Rising corporate earnings and the absence of high profile corporate scandals and accounting fraud rumors should also help to restore investors’ confidence particularly since many CEOs have had to certify the accuracy of their corporate financial filings by August 14, 2002.

Since global risks remain high, we expect the Federal Reserve to maintain their easy monetary policy. China will continue to be a source of deflationary pressure, and problems in Latin America will continue to fester; another recent troubling economic event was the IMF’s $30 billion loan to Brazil. Latin America’s problems will almost certainly add further weakness to global economic growth prospects. Under these conditions increased U.S. government spending and an overall loose fiscal policy will be a necessity. We now expect U.S. federal budget deficits to exist for a considerable period of time.

Consumer Spending

Corporate scandals and the stock market slump are threatening consumer confidence. The University of Michigan’s index of consumer sentiment fell in July and August. Consumers cited concerns about lower economic growth and higher unemployment for their pessimism. They also expressed concern that careless corporate accounting and management scandals would hurt the economy. People are also feeling the losses in their equity portfolios and retirement accounts. So far consumer spending has still remained strong. However, there appears to be an obvious disconnect between the stock market and consumer pessimism on the one hand and actual consumer behavior and spending on the other.

A weak stock market probably has yet to influence consumer spending because of offsetting boosts from tax cuts, lower interest rates, increased money supply and higher housing prices. It’s possible that with investors now worried about losing stock profits not just from the overheated years of 1999-2000 but also from the 1980’s and 1990’s, the wealth effect from the decline in equities may become more pronounced. When people feel wealthier, they spend more, generating economic activity. Once they start to feel less well off and have concerns about the future they cut back, and this could cause the economy to slip into recession. Mr. Greenspan is currently striving hard to prevent that from happening.

Market Dynamics

With the short interest on the New York Stock Exchange having risen to a record 8 billion shares from 7.5 billion shares, margin debt declining another $10 billion to $136 billion and record amounts of mutual fund redemptions occurring during July as investors became frightened and panicked, a major market decline took place. As a result insider buying has increased dramatically, and the stage has been set for a rebound. While there are now more attractively valued companies than there had been, many companies will be challenged to achieve the earnings growth necessary to support much higher stock prices. The dramatic market decline had partly discounted the earnings drag of under-funded pension plans, the expensing of stock options, the reduction of tax revenues for state and local governments, the slowdown in corporate capital spending and higher energy costs, or in other words, a slow-growth U.S. economy if not a double-dip recession. However, people who today depend on interest income from savings have less to spend because interest rates are so low. This adds to the appeal of good dividend paying equities and interest bearing bonds. In the next Outlook we will discuss some industries and companies that we believe can benefit under these circumstances.

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Risk and Return

As of May 20, 2002
Index	YTD % Change	Market Value
Dow Jones Industrials	2.08	10,229.50
S&P 500	-4.90	1,091.88
Nasdaq Composite	-12.76	1,701.59

Portfolio management is both an art and a science. It is a decision-making process that requires sifting through large amounts of information and making a judgment as to what is really important. The decision-making process at the end of the day must determine the tradeoff between risk and return. Managing risk in pursuit of investment returns is a defensive process. The most difficult aspect to proper portfolio management is the integration of clients’ unambiguous objectives, constraints, preferences and expectations with realistic and sustainable investment returns. We have entered into a difficult market cycle where valuations are generally too high and market volatility reflects economic uncertainty, weak corporate profits, and unexpected negative announcements. For the average investor this will probably increase the frequency and severity of shortfalls in meeting expected investment returns.

While high levels of risk should always be avoided, this is particularly true in the current market environment. Equity and fixed-income investments must stay well within an acceptable risk tolerance. We are concentrating on companies that can deliver earnings and dividend growth but are trading at prices that are reasonable in relation to revenues and cash flow. Faithfulness to this particular concept of investing has always required us to devote a considerable amount of time and energy to each investment decision which tended to reduce the need to revise opinions and change holdings because of disappointing new information. Our in-house research capability has often been able to isolate superior values at depressed prices and achieve superior long-term goals for clients with relatively low risk. Lack of investor confidence in financial markets has clearly made us even more vigilant.

Focus on Rapid Growth and Acquisitions

Senior management in the 1990’s often failed to strike a proper balance between risks and return that protected the company’s stockholders. Decisions relating to the extent to which debt was employed, aggressive capital spending and acquisition policies in hindsight now in many cases appear to be reckless. Management frequently had a single-minded focus on rapid growth both organically and through acquisitions. Financial leverage was used to increase revenues and raise the rate of return or profitability of a company. Insufficient attention was paid to return on invested capital, free cash flow and balance sheet issues. Ultimately we must judge equity investments on the soundness of their business models, the return on invested capital, the free cash flows, the strength of the balance sheets and the character and ability of the management team.

Management

Shareholders own companies and elect the Boards of Directors. Management, in turn, is supposed to operate the corporation in the best interests of the stockholders. We all know, however, that the stocks of most large firms are widely held, so the managers of such firms have a great deal of autonomy. This being the case, management may at times pursue goals that may not ultimately maximize stockholder wealth. It is extremely difficult to determine whether a particular management team is trying to maximize shareholder wealth or is merely attempting to enrich themselves while pursuing excessively aggressive goals. The big bonuses and generous stock options that are given out to attract and retain the managers who are responsible for protecting the interests of stockholders and keeping the company out of financial difficulty have not always delivered the desired results. Some management teams failed to take into consideration that their forecasts might be imperfect and accepted high levels of financial risk in exchange for the dream of realizing extraordinary wealth for both themselves and shareholders. Shareholders and Wall Street analysts often put too much trust in management and do not introduce uncertainty into their upside stock price assumptions or quantify downside risks.

Stock Option Grants

The current accounting rules do not require companies to count stock options granted to their management as an expense. The existence of low price stock options distorts the corporate profit picture and can increase investors’ market risk. Federal Reserve Chairman Alan Greenspan believes companies should be required to list the cost of stock options with other operating expenses like salaries and cash bonuses. Most companies issuing stock options do not count them as a cost against profits but separately disclose their potential impact on
share value in footnotes to their financial statements. In the Enron collapse and other incidents of management misconduct, the senior executives have been accused of pumping up their company’s stock price by questionable means and then cashing in on their low-price stock options. Stock option grants have grown with increasing popularity as a form of executive compensation and have simultaneously introduced a significant new distortion into the reported corporate earnings picture.

The Leverage Factor

In theory whenever the returns on assets exceed the cost of debt, leverage is favorable, and the higher the leverage factor the higher the rate of return on common equity. In the 1990’s the management of technology and telecommunication companies began to act as if they knew with certainty that sales would rise rapidly. Bonds became the preferred method of financing capital expenditures. Managements could not bring themselves to believe that their companies would not be generating enough free cash flow to cover the interest charges, and that the debt could jeopardize the very existence of their company. Generous stock option grants encouraged aggressiveness in the use of financial leverage to drive both top and bottom line growth. Over confidence in the future level of sales and profits reflected both management’s financial stake in driving up the equity value of the company and their belief in a continuation of positive economic conditions and industry trends. Managers seemed to have forgotten that the increased leverage raised the probability of business failure.

WorldCom Inc.

On April 30th, Bernard J. Ebbers resigned as chief executive officer of WorldCom Inc., the once tiny long distance company that he built into one of the world’s largest telecommunications empires, only to watch it fall into near bankruptcy. Since WorldCom hit a high of $64.50 in June 1999, it has lost more than 98% of its value. The company, started by Mr. Ebbers, is staggering under $28 billion of debt. The prospect of bankruptcy could potentially undo a series of more than seventy-five acquisitions over nineteen years that built WorldCom from a tiny phone company in Mississippi to a global giant. WorldCom is the subject of an SEC inquiry over the huge $366 million loan the firm granted Mr. Ebbers to cover margin calls on loans that he had personally backed with WorldCom stock obtained through stock option grants.
Mr. Ebbers now finds himself out of work and hundreds of millions of dollars in debt because he was wrongly confident that WorldCom would never falter. Looking beyond investor losses, there is a growing sense that WorldCom is an example of how companies should not be managed. Wall Street analysts continued to recommend the company to clients during the company’s glory days, although they complained that the frantic pace of acquisitions made it difficult to understand the company’s balance sheet, income and cash flow statements. The analysts’ task was complicated by WorldCom’s reliance on confusing accounting methods, financial engineering, pro forma figures in its financial reports and the analysts firms’ desire for lucrative investment-banking business. Merrill Lynch & Co. and the New York Attorney General Eliot Spitzer are presently trying to agree on a deal that would allow Merrill Lynch to avoid criminal charges for issuing overly optimistic research reports to investors on stocks of companies that paid big fees for their investment-banking help. We should also point out that the total investor dollar losses from WorldCom’s peak – based on the number of shares outstanding – were three times greater than from Enron’s peak.

Investor Attitudes

Regardless of managements’ analyses of the proper leverage factors for their company, Wall Street, banks and investor attitudes are an important determinant of the optimal financial structure. Those attitudes are subject to change based on market conditions, macro-economic factors and industry trends. Companies must leave sufficient head room in their capital structure to accommodate major changes in investor attitudes. Neither theory nor empirical analysis has been able to specify precisely the optimal capital structure and leverage for an actual company. Capital structure and leverage decisions are largely matters of informed judgment. An informed judgment requires that considerable analysis be undertaken, and there is an awareness that you cannot count on a continuation of favorable market attitudes toward leverage. Independent and realistic measures of assessment such as the probable cash return on invested capital are essential.

Dividends

Although both growth and dividends are desirable, these two goals in the 1990’s were viewed as being in conflict. The starting point for controversy was the belief that investors should prefer to have the company retain and reinvest earnings rather than pay them out in dividends because the return on the company’s reinvested earnings would far exceed the rate of return the investor could obtain on other investments of comparable risk. The pundits refused to consider the viewpoint that even though dividends are taxed at a higher rate than long-term capital gains, they are still important and subject to far less uncertainty than the promise of a future capital gain. We argue that the certainty factor under current market conditions should play a more significant role in investment decisions. Dividend income should be an ample component of the expected total annual rate of return in a portfolio.

Pension Funds

Almost every major pension fund in the nation has lost money in the recent stock market downturn. Companies and major public pension funds in the nation adopted an unusually aggressive stock-market-based investment strategy, which served them well during the boom times of the 1990’s but left them vulnerable to losses when the market declined. Higher pension costs are now a serious problem for many corporations and municipalities who must contribute more money to their pension funds in order to offset stock market losses. Reported earnings in recent years benefited from the bull market of the 1990’s that generated extraordinary performance for pension funds. Companies did not have to contribute money to their pension funds, and were even able to move some of the over-sized pension fund gains to their income statements. Pension-accounting rules allow companies to move excess profits in their pension funds to the income statement, even if they lose money in the current year, provided the three-year average return is above the preset three-year assumed rate of return. The mandated annual compound assumed rate of return for many corporate and municipal pension fund plans is currently pegged at 9.0% or more, which is a rate that cannot be achieved easily in the current market environment in our view.

Conclusion

Poor corporate profitability has received an enormous amount of attention in recent months with most of the blame attached to a weak U.S. economy. Analysts fail to give sufficient weight to what may well have been erroneous forecasts of unsustainable high rates of growth for the global economy and the inevitability that such high growth forecasts would lead management to errors in the form of over-optimism and over-expansion. Unfortunately attempts to reduce expectations and temper overly optimistic forecasts have spooked the security markets at a time when multiplying accounting scandals are creating a crisis of confidence among investors. The assault on Wall Street’s equity research departments by regulators and prosecutors over allegations of overly-bullish recommendations during the technology-and-telecom stock bubble also could not have come at a worse time. We suspect that some investors now may be considering moving money to the sidelines because of their concern about Wall Street’s bullish research, corporate balance sheets and pro forma accounting wizardry.

Pro forma profitability measures are calculated as if certain normal business items – usually expenses – do not exist. The wide variation in how such numbers are calculated often makes it difficult to understand a company’s financial performance, and compare it to the company’s peers.

Unveiled a new definition of so-called operating earnings on May 15, 2002 in an effort to improve the clarity of financial reporting. The new methodology excludes pension fund gains and includes the cost of stock option grants in the calculation of operating earnings. Restructuring costs and certain other “one-time-expenses” that are generally not included by many companies in their operating-earnings also will be included now. In establishing standards for how corporate earnings are calculated, Standard & Poor’s is seeking to address investors’ demands for uniform benchmarks for financial performance. The new standards will lower reported corporate earnings and raise their price/earnings multiple. Unfortunately deficiencies in reliable economic and financial information tend to make investors too cautious during bear markets and too confident and demanding in bull markets. We believe that in spite of the flawed economic forecasts and accounting methodology, our informed and rational approach to portfolio management can deliver satisfactory investment returns over time for a minimum level of risk. While the severity of the economic downturn has affected almost every industry, we believe that technology-driven productivity gains likely will lead to higher earnings and revenue for many companies as the recovery begins to take hold.

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Corporate Profits & Enterprise Value

As of April 11, 2002
Index	YTD % Change	Market Value
Dow Jones Industrials	1.5	10,176.08
S&P 500	-3.9	1,103.69
Nasdaq Composite	-11.5	1,725.24

While the U.S. economy is coming out of the recession much sooner than many expected, business profits are not likely to show a significant improvement in the first quarter. The recession masked a serious corporate profit problem that started in the 1990’s and accelerated during the recession. Most companies expect profits to slowly improve later this year, but across many industries the profit picture still remains difficult. Business investment in new technology remains weak, and many technology companies are now signaling that revenues and earnings will fall below market expectations.

After-Tax Corporate Profits

The recession was one of the worst in memory when measured in terms of after-tax corporate profits. The Commerce Department calculates that after-tax U.S. corporate profits on average declined 15.9%, one of the worst declines since World War II; however, the recession of 2001 will probably turn out to have been one of the mildest on record in terms of its impact on the real Gross Domestic Product. The real Gross Domestic Product is the market value of goods and services produced by labor and property located in the U.S. when adjusted for inflation. The after-tax corporate profits plunge was especially severe among the large capitalization companies that make-up the S&P 500 stock index and the Nasdaq Composite. In the S&P 500 stock index and the Nasdaq Composite a significant portion of the profit drop has been caused by companies implementing more conservative accounting policies associated with correcting aggressive past practices.

Accounting Practices

Companies are coming to grips with a culture of pushing the edge of the envelope on accounting practices to lower costs and inflate earnings. The Enron Corp. scandal is now forcing many companies to report their results in more realistic terms. Xerox recently was forced to restate earnings covering a four-year period and agreed to pay a $10 million civil penalty to settle SEC charges that it engaged in fraudulent accounting practices. The fine is the largest the agency has ever levied against a public firm in connection with financial-reporting violations.
The profit pressures that existed in the 2000-2001 period will not cease to exist for many U.S. companies when the recession ends. Intense global competition makes it difficult to raise prices and recover higher costs. The costs of wages, healthcare and insurance have proven difficult to bring under control. The strong U.S. dollar continues to hurt overseas profits because foreign earnings must be reported in U.S. dollars. Many companies are also being hurt by the high debt levels they incurred in the 1990’s, and are now being forced by concerned creditors to find ways to improve their balance sheets and reduce interest expense. They must continue to trim capital spending and plan additional employee layoffs. Taking on so much debt does not seem so wise in hindsight. Companies must also persist with a shift of large portions of their manufacturing facilities to China, Mexico, Eastern Europe and other low-cost countries.

Companies are now being required by outside auditors and government regulators to immediately disclose any expected charges relating to the decline in the value of assets that they carry on their balance sheets. The SEC staff has recommended enforcement action against companies that fail to provide financial information in a timely manner linked to assets whose values are known to be seriously impaired. The SEC wants companies to write-off in lump sum the assets that have fallen in value. The new rules will allow companies to stop making deductions from earnings each year for amortizing goodwill. Nevertheless many companies are facing huge goodwill write-downs after paying large premiums for acquisitions, many of which turned out to be speculative, during the technology frenzy of the late 1990’s. Qwest Communications International Inc. recently announced that it expects to take a charge of $20 billion to $30 billion stemming from changes in goodwill accounting which revealed a fall in the value of assets it acquired.

Off-Balance Sheet Liabilities

In light of the Enron collapse investors have also become skeptical about off-balance sheet items. They no longer feel confident that they know all the facts about what is going on inside a company when off-balance sheet liabilities exist that are not fully disclosed. Questions about Enron’s accounting practices led to a sudden decline in the value of the company’s stock. This in turn had serious implications for both its shareholders and its debt-holders, and the company immediately had trouble meeting all its financial obligations. When you add the off-balance sheet debt to overall debt, the most salient question becomes whether the higher figure exceeds the debt to cash flow limits of covenants with lenders. If so, lenders could decide they are not comfortable with the higher debt levels. In Enron’s case this resulted in loan calls that forced the Houston-based company into the largest U.S. protective bankruptcy filing ever.

Corporate Enterprise Value

The standard which should apply when making an equity investment is what the entire business costs on the basis of its current market value and financial commitments rather than just whether the stock price is up or down over a given time period. The basic measurement for determining this value is the market value of the company based on the stock price multiplied by the number of shares outstanding plus the debt that the company owes to its creditors. This measurement is commonly referred to as the enterprise value of the company; it is what you would have to pay to buy the entire company and assume the debt obligations. Before major investors make an assessment to acquire a company they have to feel comfortable with the assets, revenues, profits and free cash flow that the business can generate in the future relative to the business’s current enterprise value. The accurate financial reporting of corporate operating performance and the proper disclosure of assets and liabilities are fundamental to settling on the worth of a business.

The enterprise value that the market places on a company obviously requires a judgment that the company’s current stock price properly reflects forecasted asset values, revenues, profits and cash flow and the risk of error in the forecast. While analysts have their preferences for testing enterprise valuation, the most pragmatic approach in our opinion uses price to sales, price to earnings and price to free cash flow as the key appraisal measures. Price to sales is an important litmus test in the valuation of a company, since the price that a businessman would pay for ownership of a company is rarely more than several times annual revenues. However price to earnings is the most commonly used approach to measure market valuation, and it is often compared to the company’s projected annual earnings per share growth rate. From a purely historical perspective it is generally a bad choice to invest in stocks that are selling at price to earnings ratios that are significantly higher than their sustainable earnings growth rate. Finally, we recognize that companies need to generate free cash flow to remain competitive and grow the business. A growing, profitable firm will likely need to borrow capital for investments in plant & equipment, receivables and inventories. Debt unfortunately carries with it commitments and covenants that can easily place a business in mortal danger if its operating cash flow is suddenly not sufficient to service the debt. Price to free cash flow is undoubtedly one of the single most important measures of valuation.

The Equity Market is a Medium of Exchange

The equity market is a medium of exchange where cash is exchanged for ownership in what is presumed to be successful ongoing businesses. The equity investor must have confidence in the company’s business model, revenues, profits, cash flow and assets in order to make the exchange. The decision that ownership in a company is a better value than a risk free investment in cash is fundamental to the viability of the equity markets. Cash is defined here as government securities or other forms of relatively safe assets in which the principal and interest are assured. Investors have relied upon the accounting industry to set strict standards for the preparation of the financial statements that allows them to make intelligent decisions as to the desirability of substituting cash for ownership. Arthur Andersen LLP’s audits of Enron, Waste Management and others continue to soil the accounting industries’ reputation. Andersen allowed Enron to overstate earnings back to 1999 by almost $600 million. In the case of Waste Management, the SEC alleges in a lawsuit that former Waste Management officers, aided by Andersen, concocted “a systematic scheme to falsify Waste Management’s earnings and other measures of financial performance”, under which the company overstated its pretax profits by more than $1.7 billion from 1992 through 1997. Disclosures of impropriety in the preparation of financial statements have damaged investor confidence in the equity market as a medium of exchange and made it more difficult to measure the worth of a business.

Equity Risk

Equity risk is not an easy concept to grasp, and a great deal of controversy has surrounded attempts to define and measure it in the 1990’s. However, the most common definition of equity risk, and one that is best for our purposes, is to define risk around the likely variability of the company’s forecast of future asset values, revenues, profits and free cash flow. Any equity investment decision implies a forecast of future events that are most likely to happen; it is the best estimate after considering the competitive business environment and the state of the economy. The risk of not achieving a satisfactory rate of return on an equity investment relative to a risk free return on cash is greatest when the equity’s enterprise value is lofty and the expectation of a higher return is being forecast out into the distant future. Most individuals prefer a modest level of risk in exchange for a higher rate of return, but both logic and observation suggests that investors can tolerate only minor and infrequent losses. The desirability of equity investments to other potential opportunities involves carefully balancing the tradeoff between risk and return; and it ultimately always boils down to the investment’s current enterprise value. In the final analysis investors are really looking for compound rates of return, so minimizing losses becomes vital to achieving investment results.

Chronic Overvaluation

We believe that parts of the equity market are currently overvalued based on our enterprise value calculations. The market’s chronic overvaluation stems from the philosophy that above-average earnings growth over time will produce above-average returns regardless of valuation. The idea had considerable appeal in the 1990’s and resulted in the payments of excessive prices for companies that appeared to have extraordinary growth prospects. The idea has recently had a serious setback particularly in the technology and telecommunications sectors. Great companies selling at high prices are not great investments. Excessive prices were clearly based on a gradual build-up of unrealistic future growth expectations. Stocks become very popular or unpopular over time because high valuations unfortunately convey an impression that everything is fine and low valuations often have the opposite effect that something must be wrong. The objective is to achieve a satisfactory rate of return relative to a risk free return on cash. In an acknowledged partly-overvalued market we can still find sensibly valued stocks across diverse market sectors that have business clarity, possess strong balance sheets and pay dividends, but currently are not so popular and can produce satisfactory compound rates of return.

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As of March 14, 2002
Index	YTD % Change
Dow Jones Industrials	4.9
S&P 500	0.4
Nasdaq Composite	-4.9

It appears that investors are seeking to make rational investment decisions in companies that have business clarity, possess strong balance sheets and pay dividends. The dot-com boom/bust and the collapse of many of the technology and telecommunications companies’ equity values have fostered a more value-conscious investor mind-set. September 2001’s great fear and pain over terrorism and the economy have also slowly given way to anxiety over financial statements and their accounting integrity. Enron, portrayed as the seventh largest company in the U.S. by revenues, was forced to seek bankruptcy court protection after disclosing questionable accounting practices, previously undisclosed liabilities, and overstated assets and earnings on their financial statements.

U.S. Economic Recovery

A U.S. economic recovery is gaining momentum as inventories are being rebuilt, and this could mean the recession may turn out to be shorter than originally feared. Gross Domestic Product showed a faster-than-expected 1.4% annual growth rate in the fourth quarter of 2001 propelled by consumers and a big rise in government spending. The Labor Department’s statistics on U.S. workers filing first-time applications for unemployment benefits has shown some improvement. Separately, the Commerce Department’s statistics indicate that more sales are now being filled from new production rather than out of existing inventory. Some economists believe the data suggests that the job market is improving, and companies are increasing production and successfully matching supply with demand. Despite some favorable developments suggesting an economic recovery for both Gross Domestic Product and profits, major market indexes have generally been mixed in the first quarter of 2002. The economy will continue to battle numerous headwinds against economic growth. However the more positive growth outlook, coupled with investors’ more rigorous reviews of corporate accounting and disclosure, should make the next several months an important window of opportunity for sector selection and stock picking.

Fixing the Accounting System

Not long ago, accounting was considered a highly technical and somewhat boring subject. Today, with the controversy swirling around the Enron collapse, it is now an important fundamental investment consideration. Arthur Andersen LLP, Enron’s outside auditor, has begun the arduous task of negotiating a settlement with Enron’s angry shareholders, creditors and employees. Arthur Andersen LLP is also facing a credibility crisis, a justice department indictment and an investor revolt that threatens both Andersen’s survival and their clients’ equity valuations. Unfortunately, the accounting profession with the help of the Wall Street investment banking community has often been adept at defeating needed reforms. The industry’s current practice of providing clients with both auditing and consulting services has a conflicted and checkered past. A forced breakup of the accounting profession’s auditing and consulting functions now seems likely to occur. Congress, government agencies, investors and the big accounting firms themselves have begun to call for a major government mandated reform. Companies are being forced to open their books and issue clearer and more detailed disclosures of what they are doing both on and off their balance sheets and through their income statements.

Fixing the accounting industry’s flawed system of self-regulation will almost certainly be done through both Congressional and SEC action. The road to reform will pass through Norwalk, Connecticut where the Financial Accounting Standards Board, a private sector body that is funded largely by the accounting industry itself, sets standards for the financial statements upon which investors currently must rely. Many people both in and out of the government feel that accounting standards need to be carefully monitored by the federal government. It comes as a surprise to many investors that the accounting rules for the preparation of financial statements allow wide latitude in how they are applied. If investors have their way, the SEC and other federal agencies would place rule-making powers of the Financial Accounting Standards Board under tighter control.

The Economy of the 1990’s

The economy of the 1990’s was not as good as it seemed. It is clear that the economy and business investment in technology and telecommunications grew at an unsustainable pace. Investors have also learned that Enron, Global Crossing, Computer Associates, Lucent, Tyco, Sprint PCS, Waste Management and others did not earn as much money as they said they did. The dot-com boom/bust continues to work its way back through the economy. It hurt the PC makers and their suppliers and Internet device companies like Cisco and semiconductor equipment manufacturers.
It is now next to impossible in this environment for many information-technology companies to raise new capital. The storm is threatening companies with solid long-term business plans that may be in need of additional capital. The situation is not helped by the fact that some companies in the industry are being probed for erroneous accounting of their revenues and costs during the 1990’s. Regulators suspect the way they booked certain items may have inflated revenues and depressed costs thereby boosting reported profits. It is hard to predict for example when the debt crisis for companies that spent to build costly broadband networks will end. Growth of new cell phone users has also slowed. It will probably take a sustained pickup in the economy to improve credit quality and restore investor confidence in the telecommunications industry. The overabundance of capital spending in the 1990’s on information-technology contributed to the sharp downturn in the U.S. economy.

Semiconductor Industry

The U.S. business-led decline in technology spending had sharply reduced the need for semiconductors and new semiconductor manufacturing equipment. However, demand for leading-edge equipment is beginning to increase. Wall Street is now anticipating a recovery in technology spending and in turn, the semiconductor industry. The glimmers of hope in the economy have resulted in a big run-up in semiconductor industry stock prices. The key consideration for investors at this juncture, however, is whether expectations have become overly bullish. For our part, we suspect that may be the case in the short-term. The stock market seems to be pricing semiconductor stocks as if a strong recovery for the industry is in progress, when in fact, the near term outlook is still difficult. It is unlikely that U.S. businesses will aggressively boost information-technology spending levels until more tangible signs of a sustainable rebound become more evident. The communications industry, an increasingly significant end market for semiconductor devices, could remain weak throughout 2002. Semiconductor stocks are super-cyclical and respond both on the upside and the downside way in advance of genuine changes in their revenues and profits. However, the opportunity is still greatest for those companies benefiting from increasing demand which is currently underway for leading-edge technology.

Money Center Banks

The mixture of leverage and deflation is causing the banking industry to reevaluate its credit risk tolerance. Tight lending standards will retard loan growth for large money center banks and create potential risks for some highly leveraged industries. Investors are demanding that both the banks and their clients disclose financial data that may be relevant to credit quality and to identify triggers and other forms of conditionality in financial agreements. Additionally, investors are concerned that the Federal Reserve often does not appear to know what is happening at the banking institutions that they supervise. The heavy volume of trades between the offshore operations of a division of J.P. Morgan Chase & Co. called Mahonia Ltd. and Enron surfaced in litigation connected with Enron’s bankruptcy-court filing. The trades have raised questions as to whether J.P. Morgan Chase & Co. was a vehicle for loans disguised as trades that helped Enron draw a misleading financial picture for investors. We have generally reduced our positions in large money center banks because of our concern that the global recession will ultimately lead to higher non-performing assets and charge-offs.

Defense Stocks

Defense companies remain attractive because military spending is climbing and is likely to do so for the foreseeable future. A dangerous enemy has attacked the U.S. and the government must provide the means to fight this enemy around the globe. With the combined market value of the nine largest U.S. defense contractors being less than $190 billion, the entire defense sector’s representation in the S&P 500 index consisting of these nine companies is only 1.77%. The nine largest U.S. defense companies in the S&P 500 index had combined revenues of $183.6 billion in FY 2001. For comparison purposes Microsoft has a $336.5 billion market value on only $25.4 billion in revenues in FY 2001. Microsoft currently represents 3.13% of the S&P 500 index. Microsoft’s price/earnings multiple is 34 X, assuming their costs are not understated, compared to the nine largest defense contractors’ average market-weighted price/earnings multiple of 18 X. It is clear that increased spending on national defense is the reality for years to come and the stock prices of the largest defense contractors do not fully reflect that reality or their hefty order backlogs and cash flows from operations.

Property-Casualty Insurance

The tragic events of September 11th, the Enron collapse and a growing scrutiny of corporate America’s balance sheets should have a positive effect on the property-casualty insurance industry’s premiums and combined ratios. The industry has been hurt by exposure to asbestos claims, the attack on the World Trade Center, environmental issues and home repair inflation and mold contamination. Going forward we expect the property-casualty industry to benefit from higher pricing and better underwriting margins. We expect rate increases of over 15% for the full year in 2002 and believe this pricing trend will continue for the next several years. The industry will no longer provide terrorist-related catastrophe coverage as existing policies come up for renewal. In the few cases where an individual state might require them to offer coverage, the premiums will be prohibitively expensive. The federal government will ultimately have to pass legislation designed to provide excess liability coverage for terrorist-related catastrophes or affordable coverage will not be available. Without terrorist insurance legislation the banks could be assuming greater loan-loss liabilities.

Homebuilders

We also have liked residential homebuilders because mortgage rates are still low, unemployment is easing and consumers remain confident about the future. Moreover, sales have been helped this year by a mild winter. The industry continues to benefit from improved efficiencies derived from increased worker productivity and aggressive cost cutting. Homebuilders have the ability to raise average selling prices and improve profit margins because of the supply/demand imbalance created by a shortage of quality building sites and favorable U.S. demographics for home ownership. The higher-than-expected margins on home building, coupled with favorable mortgage rates, should continue to drive bottom-line profits. The industry seems poised to have record earnings in both FY 2002 and FY 2003.

Health Care, Food and Beverage and Consumer Product Companies

In our opinion, many of the health care, food and beverage and consumer product companies are interesting as they have excellent cash flows, strong balance sheets, and pay attractive dividends that appeal to a market gripped by credit concerns. As a group they have solid earnings’ visibility and often the capability to reduce costs or raise prices in a deflationary environment. However as has been the case for many years, these companies have generally only mid-single digit organic growth potential and relatively high price earnings multiples. New product introductions and meaningful stock repurchase programs are the other significant drivers of their positive earnings-per-share outlooks. Additionally, innovation and heavy research and development spending, as always, have been extremely important for their successes. We find investment opportunity at attractive valuations from time-to-time in this sector. The single-minded focus on core businesses and strong free cash flow continue to be the chief reasons for the sector’s impressive market performance.

U.S. Natural Gas

As a final point the current valuation of the U.S. natural gas energy companies is too low in our view. Our valuation assessment is based upon the strategic importance of North American natural gas and oil reserves, strong cash flows, and merger and acquisition activity. At issue with investors in the industry is the use of leverage and off-balance sheet financing-vehicles similar to the ones that contributed to the collapse of Enron. Unlike Enron, most of the natural gas companies in this industry are in excellent financial condition. Their obligations are secured by tangible assets operating under long-term contracts. The industry as a whole is taking the necessary steps to maintain investors’ confidence by improving their financial accounting and reducing the overall leverage on balance sheets. Despite the recent pullback in natural gas prices, the industry should enjoy rising demand and good top-line revenue growth. Moreover America’s energy dependence on foreign sources underscores the strategic value of domestic reserves.

After-Tax Corporate Profits

From 1996 to 2001 after-tax corporate profits relative to the Gross Domestic Product have declined. In 1996 the U.S. economy’s Gross Domestic Product was $7.8 trillion and grew 19% to $9.3 trillion in 2001. At the same time after-tax U.S. corporate profits in 1996 were $502 billion and declined -5% to $475 billion in 2001. The point being made is that after-tax corporate profits have continued to decline in both good and bad economic times relative to the Gross Domestic Product. The disinflation/deflation effect from low cost overseas manufacturing has put considerable pressure on pricing and U.S. corporate profits. The market sectors that have been highlighted in this outlook are likely to have superior top-line growth with enhanced operating margins and solid bottom-line profits despite the pressures on overall after-tax corporate profits.

Summary and Conclusions

A U.S. economic recovery could be gaining momentum and the recession may turn out to be shorter than originally feared. Wall Street is now anticipating a recovery in technology spending and in turn, the semiconductor industry. Gross Domestic Product showed a faster-than-expected 1.4% annual growth rate in the fourth quarter of 2001, propelled by consumers and a big rise in government spending. In this environment we find defense stocks attractive as military spending is climbing and is likely to do so for the foreseeable future. The tragic events of September 11th, the Enron collapse and a growing scrutiny of corporate America’s balance sheet should have a positive effect on the property-casualty insurance companies’ premiums and combined ratios. We also like companies associated with the housing industry because mortgage rates are still low, unemployment is easing and consumers remain confident about the future. Additionally health care, food and beverage, and consumer product companies are interesting as they have excellent cash flows, strong balance sheets and pay attractive dividends that appeal to a market gripped by credit concerns. As a finalpoint, the current valuation of the U.S. natural gas energy companies is too low. Our valuation assessment for natural gas energy companies is based upon the strategic importance of North American natural gas, rising demand and top-line revenue growth.
The forces at work in the economy and the equity markets are not all that difficult to see and understand. If corporate profits continue to weaken relative to the U.S. Gross Domestic Product, equity multiples are likely to remain under considerable

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As of December 31, 2001
Index	YTD % Change
Dow Jones Industrials	-7.10
S&P 500	-13.04
Nasdaq Composite	-21.05

The Standard & Poor’s 500-stock index ended 2001 down –13.04% the second straight year the index fell more than -10%. The Nasdaq composite index which includes many information technology and biotechnology stocks, performed even more poorly, losing -21.05 % after a -39.3% loss in 2000. The average stock mutual fund fell -11.9%, but growth stock mutual funds, the most widely held type of stock mutual fund investment, slid -17% in 2001.

U.S. Economy

A year ago few forecasters realized how sharply the U.S. economy would turndown and how severe the impact would be on corporate profits and on many stocks. Now the important question for the global economy is the timing and strength of a U.S. economic recovery. We believe that the recovery will be more sluggish and erratic than has been the norm; notwithstanding the fact that inventories are now beginning to be rebuilt giving the appearance that the economy is starting to recover. The surprisingly strong NAPM report indicating that new orders and production in the manufacturing sector have improved in combination with an improvement in December retail sales has lent support to the notion of an economic upturn. What makes the outlook so difficult to determine is the fact that there are powerful deflationary forces in the system that will continue to work against the positive dynamics that have been established by the government’s aggressive monetary and fiscal policies. In spite of the failure of the last session of Congress to pass a tax reduction bill, the prior tax relief legislation will reduce tax rates in 2002. The challenge this year will be to build equity portfolios around companies that generally have strong balance sheets, positive operating cash flow and an improving earnings outlook.

A recent survey of chief financial officers of U.S. companies indicated that they expect the recession to stretch into the second or third quarter of this year. Sales and earnings remain weak for most companies, and most expect only a modest improvement for their business over the next six to nine months. The recession continues to be a business-led recession brought about by a sharp contraction in capital spending which hit technology, telecommunications, and manufacturing relatively hard versus the overall economy. Corporate capital spending usually is viewed as critical to long-term business survival but is often based on whether the current economic times are good or not.

Credit Conditions

Despite the Federal Reserve’s eleven interest rate cuts last year, many companies trying to borrow money find credit tight. Enron’s collapse has created issues for the credit markets. In November Enron Corp. was burdened by nearly $40 billion in debt and forced into Chapter 11 bankruptcy by creditors. The accounting firm Arthur Andersen LLP, Enron’s outside auditor, failed to uncover serious errors that reflected undisclosed leverage in Enron’s financial statements. The financial markets are concerned as to what might happen if there are more companies like Enron out there and the economy continues to weaken.

There now is a widespread consensus that at the very least the nation needs stricter accounting rules to force companies such as Enron to do a better job of disclosure. The financial system remains sound, but we expect investors and debt-rating agencies to raise the bar for financial reporting. Companies that have strong balance sheets and are on track to boost cash flow this year will be rewarded with easier credit terms and a higher stock price. The strong companies also will find themselves well-positioned to increase their market shares and improve their cost structures by buying weaker companies for little or no premium over existing stock valuations.

Profits

We believe that corporate profits are going to be under pressure for the entire year. One of the things that corporations have given us over the last several years, even during good times, is huge write-offs and unexpected liabilities that never seem to stop. This year is probably not going to be much different. One of the big surprises may be that pension fund liabilities have increased dramatically in many cases as investment rates of return over the past two years failed to meet pension fund assumptions. The difference between actual rates of return and the assumed rates of return must be made up from corporate earnings. If this proves to be the case, what investors might have to accept are corporate profits at lower levels than they now expect.

Federal Reserve

The Federal Reserve has cut short-term interest rates below 2% for the first time in 40 years and left the door open for more cuts. It has remained skeptical that the recession is coming to an end. Continuing its most aggressive rate cutting in decades, the central bank reduced its target for the federal-funds rate last month to 1.75% from 2%. Federal Reserve officials had feared the economy could go into a free fall in the wake of the September 11th terrorist attacks, and are relieved it did not, giving them the freedom to cut last month by only a quarter point. The Federal Reserve also appears to want to counter expectations that interest rates will be heading up this year. The bond market has priced in a slight chance for a 12th rate cut from the Federal Reserve when the Federal Open Market Committee meets in late January.

Zero-Interest-Rate Financing and Low Mortgage Rates
Automobile zero-interest-rate financing and the low mortgage rates have helped car sales and home building. The automotive and housing sectors were two of the few bright spots in the economy last year. The housing market put on a particularly solid performance last year, and it continues to be an area of the economy that will probably hold up remarkably well in the face of the recession. Automobile sales and home building have hardly experienced a slowdown and therefore will not lead a broad U.S. economic recovery this year. The automobile and home building industry may even settle back this year from their heightened performance in 2001.

Energy

So far the fears of a plunge in oil and natural gas prices following the September 11th terrorist attacks have not been totally realized. Oil and natural gas prices have held at profitable levels despite some visible weakness in demand. Now worries are turning to OPEC’s and Russia’s ability to restrain production in a weak global economic environment. Russia, where oil production is on the rise, will remain a problem for OPEC for the foreseeable future. OPEC currently produces about 40% of the world’s oil. If the supply-demand balance for oil and natural gas is maintained, the consensus opinion regarding prices is that they will stay around current levels. While oil and natural gas stocks have bounced off the bottom of their recent lows, the risk–reward for owning the companies that we like in the energy sector remains very reasonable and continues to be of strategic importance for investment portfolios.

Economic Indicators

The debate on Wall Street is how weak corporate earnings really will be this year. Although quarterly comparisons for the next two quarters will be negative, the optimists are hoping that since earnings have been soft for the past two years, it will be easy for corporate profits to start showing strong gains as the economy climbs out of the bottom of the recession. In reality there is no guarantee that the economy has stabilized or that the weakness will not intensify this year. The December employment report indicated that the unemployment rate now stands at 5.8% – the highest level in six years. Despite the continued decline in payrolls, the report also suggested the rate of change is abating. While the employment situation may still become worse before it gets better, it is important to remember that employment is a lagging economic indicator. Lagging economic indicators are not good at predicting the future.

The leading economic indicators, which often foretell the future, are beginning to register more pluses than minuses. Six of the ten components in the November leading economic indicators were positive. This does not mean that the U.S. economy has bottomed or is about to come roaring back to life. It does suggest that thanks to a variety of factors, the government’s monetary and fiscal stimulus is finally showing up in the data. Consumers seem largely undaunted by high unemployment and lingering uncertainty about the strength and timing of an economic turnaround. The unemployment rate is up, but it is not historically high, and many companies continue to add jobs. The sharp drop in interest rates, the absence of inflation, and lower energy prices have increased the buying power of the average household. Another plus for the economy is the sharp decline in business inventories. They have been falling for the past twelve months and had a 1.4% plunge in October. The record number of cars sold in October helped clear out huge amounts of inventory and prompted car makers to announce plans to increase production. Finally, the Federal Reserve has been pumping liquidity into the economy at a fast and furious pace. The M2 money supply, adjusted for inflation, is growing at one of the fastest rates in the past thirty years. The banks are flush with cash and quite willing to lend money to credit worthy customers that have strong balance sheets and positive cash flow.

Interest rates matter, as evidenced by the 24% rise in October auto sales driven by zero-interest-rate financing. American consumers slowed their buying of cars in November and December from October, but still pushed sales for 2001 to the second highest level ever. If 30-year mortgage rates again drop below the 7% level, cash coming out of consumers’ monthly mortgage payments from refinancing could be significant. This would allow for both household debt reduction and increased spending potential. U.S. companies will also enjoy added financial flexibility from lower long-term interest rates as they reduce their interest expenses and extend maturities.

Europe

While the U.S. is fighting a recession and a war on terrorism, Japan and Europe are fighting serious internal structural problems that retard growth. It often appears at times that they are losing. With unemployment rising and important elections in Germany and France less than a year away, we believe the odds now favor interest rate and spending initiatives that will appease voters. Europe’s Central Bank has provided too little economic stimulus too late, which could push jobless votes to move further to the left in search of stronger socialist leadership. This unfortunately could further undermine the euro as markets become concerned that the Maastricht Treaty guidelines for limiting deficit spending and inflation could be in jeopardy. For most Europeans, the euro now becomes reality for the first time, as they surrender their marks, lire, francs and nine other currencies.

Japan

Japan continues to slip deeper into a recession. Most of Japan’s economic indicators do not look good, and there are indications that the situation could get worse. Exports, which have been key to pulling Japan’s economy out of recession in the past, are shrinking as demand for goods falls in the U.S. and Europe. Corporate earnings are plummeting and could fall further as accelerating price declines undermine profits. Japan is struggling to cut back on the massive government spending that propped up much of their economic growth over the past few years. There are signs that the widespread weakness in Japan’s economy is provoking the corporate restructuring and bad-debt cleanups long considered a prerequisite for Japan’s economic recovery. Meanwhile, the jobless rate in Japan rose in November to 5.5% and the yen continued to sink to new lows against the U.S. dollar. These conditions could weaken further as China becomes a more formidable competitor.

China

China formally became a member of the World Trade Organization on December 11, 2001. Many U.S., European and Japanese companies will now lose quota protections and face stiffer competition from China. China now can ship its goods to the U.S. using the same low tariffs America grants to most other trading partners. The main achievement of the agreement is China’s guarantee to give foreign companies greater access to Chinese consumers. It will particularly help pry open the Chinese market to many foreign technology, telecommunication and financial service companies. Other items covered in the agreement are the right of foreign companies to choose a joint venture partner instead of requiring them to accept partners chosen by the government, and the accelerated timetable for the issue of licenses for U.S., European Union and Japanese companies to do business in China. The ability of U.S., European and Japanese companies to shift manufacturing to China from higher-cost countries will have a significant disinflation/deflationary effect on the global economy. The overall U.S. consumer price index (CPI) will probably increase less than 0.5% in the upcoming twelve months, the smallest increase since 1959. The disinflation/deflation effect from China on the global economy will continue to put considerable pressure on pricing and corporate profits.

Stock Market

Stock multiples are probably too high for the stock market to have a sustained rally this year without a significant improvement in the U.S. economy and corporate profits. However stable interest rates and excess liquidity in the U.S. economy have continued to support the stock market. The stock market should remain at current levels in this stage of the investment cycle until better economic results and improved corporate profits take some of the pressure off high valuations. We see the prospect of an additional interest rate cut by the Federal Reserve and a meaningful fiscal stimulus package crafted by the U.S. Congress as being helpful if these occur. A stable U.S. dollar versus the euro and the yen and sustained lower energy prices are also important catalysts for a U.S. economic recovery this year. The best that can be expected from American consumers is that their spending continues at a steady pace, keeping the U.S. economy afloat, and in the process buying the time needed for a turnaround in other sectors of the economy. Economic growth will be considerably more difficult to achieve this year if consumers decide to cut back on spending in order to increase their savings rates or pay down household debt.

Conclusion

The key to a real U.S. economic recovery is the ability of American companies to increase their capital spending in order to expand workers’ productivity at an accelerated rate. In the 1990’s U.S. companies enjoyed unusual profit growth from productivity gains from capital spending on new equipment and information technology. The productivity of the U.S. worker is now probably 30% above that of other industrial nations because of those investments. Some respected economists argue that the sharp increase in capital spending in the 1990’s led to unsustainable economic growth and brought about an old-fashioned boom/bust cycle. We believe the clearest sign that the recession is in fact finally over, and that the economy has entered into a period of expansion will be when businesses once again begin to increase capital spending on new equipment and information technology. Orders for high-tech equipment, which plunged more than 50% between May 2000 and September 2001, rose in both October and November. Businesses generally need a strong profit potential and a good business environment before they decide to increase capital spending substantially. The companies that generally have strong balance sheets, positive operating cash flow and an improving earnings outlook will be the first to increase their capital spending.