Investment Outlook

	January 14, 2002
	he performance of equity markets in 2001 was poor. The total return of the S&P 500 was -11.9%, following the -9.6% return in 2000. Not since 1974 has the S&P 500 declined in two consecutive years. The health and behavior of capital markets can be significantly influenced by world events such as the horrific tragedy at the World Trade Center and Pentagon on September 11th. It is a great tribute to the monumental efforts of both the public and private sectors that after less than one week, securities trading resumed without any significant glitches. The quick response taken by the Federal Government in the form of relief and the massive liquidity injected into the monetary system by the Federal Reserve were critically important. The consequence was that in one month the market retraced the sharp sell-off during the week of September 17. Summary and Conclusions We foresee a recovery, albeit mild, in the U.S. economy during 2002. GDP growth will not resume much before the second half and for the full year, we expect real GDP to rise in the 1%-2% range. The critical question will be the strength of the U.S. economy in 2003. Corporate profits will increase in 2002, but not fully recover to 2000 levels. There are sound reasons for believing that the turnaround in corporate profits will lag the rebound in GDP. We expect positive returns from equities during 2002. While total returns could exceed 10%, we are skeptical that this level is sustainable. The bullish story this year is that investor expectations are inflated, a recovery in the economy is anticipated and low interest rates make investors more willing to move up the risk curve into common stocks. However, looking out over the next few years, it is not reasonable to expect the market to sustain double-digit returns because stock valuations are already high and corporate profits are problematic. Bonds are not attractive in our view because current yields are low and do not adequately compensate investors for the pricing risk should interest rates rise as the economy recovers. Prospective Changes and Trends in the World Arena Developments over the past year underscore the risks of the world in which we live. Nevertheless, there is good reason to be hopeful that major war can be avoided, regional conflicts in time will be resolved, and a climate favorable to business and investment will prevail. The following are some thoughts that will have a bearing on the flow of investment capital: The War on Terrorism and World Peace. 9/11 and our engagement in Afghanistan have changed the political focus from domestic issues like healthcare and drug benefits for the elderly to defense and homeland security. Relations between the United States and the Great Powers. Our relationship with Russia will continue to improve as evidenced by our working together in the War on Terrorism. There is a good chance that Russia will join NATO in time. This trend will not only have constructive geopolitical implications but should result in greater flows of investment capital to Russia. Russia will become a major factor in the supply and pricing of oil in world markets. Similarly our relations with China will improve owing to increased trade and direct investment. China’s joining the WTO was a positive development. The Dollar. The vulnerability of the United States as a terrorist target but more importantly the introduction of the Euro may present a real challenge to the dollar as the dominant reserve currency. A U.S. Energy Policy. The heightened awareness of the instability of the Middle East may finally stimulate the formulation and implementation of a viable U.S. energy policy. Reference is made to the recent increased government allocation of funds for fuel cell research. Back to Basics. While the 1990s represented a decade of great U.S. investment expansion, with the world as our battleground and the mighty dollar and technology as our most formidable weapons, the current decade may see a greater emphasis on protecting our turf, rationalizing productive capacity and resources to improve profitability and returns, and adopting a more conservative approach in business and other sectors of our society. Prospects for the Economy At the end of the third quarter, the U.S. economy was officially recognized in recession, following two consecutive quarters in which GDP declined. Thus ended one of the longest uninterrupted periods of expansion in U.S. history. We offer two conclusions: first, that the recession will be mild—hence, we feel there is little risk that the U.S. economy could drift into a deep recession; and second, that the predicted upturn by mid-2002 could take longer to gain traction and will not likely be robust. The mainstays of the economy during the period of expansion from 1991 to 1999 were the growth in capital expenditures and consumption. Business invested heavily in capacity and new technology, mainly computers and telecommunications equipment. We know from the benefit of hindsight that capital expenditures reached unsustainable levels. U.S. companies now find themselves with considerable underutilized capacity. For example, factory utilization presently stands at around 74%, which is low by historical standards. Excess capacity extends to service businesses as well. In short, companies have excess equipment, excess plant and office space and excess employees. Although reductions by companies are being made in all these areas to match resources with sustainable business needs, it is not clear how long the adjustment process will last. In one area of excess—inventories—surpluses are being rapidly brought into line. Higher production levels planned in the auto industry, for example, during the first half of 2002 should provide a healthy stimulus to GDP. Consumption, which accounts for around two-thirds of GDP, grew at unsustainable rates in the 1990s. The rate of new job creation, the expansion of the labor force and the willingness of consumers to spend more than their disposable income fueled consumer outlays. The personal savings rate became negative. While the available data do not yet indicate an outright decline in consumption, there is clearly little, if any, growth. The prospects are not favorable. The consumer is spent out. Scattered signs of robust spending seem to depend on deep discounts and bargain financing arrangements. As one observer wryly commented, “Americans will always reach for a good deal!” But in our view, there is not a lot of pent up demand left and resources are limited. Consumers in the coming months will restore their liquidity, reduce debt and increase their savings rate back to more normal levels, all of which will serve to restrain growth in consumption and GDP. There are a number of reasons why we believe that the current recession will be mild. First, low interest rates are a stimulus. Second, the Federal Government budget’s shift in the current fiscal year from a surplus to a deficit will provide support for the economy. Expansionary actions include: (a) the tax rebates and rate reductions; (b) greater military expenditures; and (c) aid to New York City, the airline industry and other expenditures such as airport security related to September 11th. A stimulus package may still be enacted, although there is some question as to the extent of the impact. Third, the economy will meaningfully benefit from a substantial reduction in energy costs. Our best estimate is that GDP will fall in the area of -1% for Q4, 2001, will show little if any growth in the first half of 2002 and will gradually increase by 2% or more in the second half. While our forecasts are subject to error, the bottom line is that growth this year will be anemic and most assuredly less than the long-term trend for the United States of 2.5%-3.0% per annum. Corporate Profits We are cautious in our outlook for corporate profits. S&P operating earnings per share, which were reported at $50 in 2000, are expected to decline 12%-15% to approximately $43.25 per share in 2001. Measured on a comparable basis, we look for a partial recovery in 2002 on the order of 8%-10% to the area of $47.50 per share. Intense competition, low inflation and excess capacity mean no pricing power and compressed margins. The heavy capital expenditures in plant and technology throughout the 1990s raised fixed costs. U.S. corporations have heavy debt loads, which in a weak economy and low inflation environment are burdensome. The strong dollar has reduced our competitiveness in world markets and has penalized the contribution of U.S. corporate earnings derived from foreign operations. Market Outlook The combination of an economic recovery and low interest rates should result in higher equity markets in 2002. However, the challenging business environment and very low rates of inflation will have a dampening impact on corporate earnings. While equity prices in 2002 could appreciate at 10% or more, these returns will be driven more by inflated investor expectations than underlying economic fundamentals. Over the next few years we expect sustainable equity rates of return in the 7%9% range. Valuations are historically high. At year’s end, the price/earnings (P/E) ratio of the S&P 500 index on estimated 2002 earnings was 24 times. Although there is justification for high P/Es in a low interest-rate environment, there is not much room for the Federal Reserve to drive interest rates lower. Hence we see no broad expansion in P/Es above current levels. Bear in mind that the outsized returns on equities realized in the 1995-1999 period rested on a substantial increase in multiples. Assuming no change in P/Es, common stocks would be expected to appreciate in line with corporate earnings—hence our projection of single-digit total returns. If the economic recovery stalls or corporate earnings unduly languish, equity returns will be penalized. On the other hand, if the economy recovers, as we believe, interest rates will likely rise, causing some shrinkage in P/Es and a drag on common stock appreciation. Because the market anticipates by six to nine months the level of economic activity and corporate earnings, the major question for investors is: what will happen to the economy and corporate profits in 2003? We are cautiously optimistic. It is a good bet that the economy will show an improvement during the course of this year with higher growth rates in 2003. At worst, the economy will grow slowly next year. Bond returns will be a drag on balanced portfolios. The favorable returns from fixed-income securities during the past two years when bonds outperformed common stocks were, in large part, attributable to the fall in interest rates, resulting in bond price appreciation. Because we place a low probability on a deep recession, it is unlikely that interest rates will decline meaningfully from current levels. Indeed there is real risk that interest rates will rise during the course of 2002, which would adversely impact bondholders. The time has come to increase equity allocations and to reduce fixed income positions where appropriate. Our equity focus will tend to be on companies in which the visibility of earnings is high until such time as the economic outlook becomes clearer and the predictability of corporate profits improves. The investment environment remains challenging. Some Loose Ends There still remain a number of outstanding issues in the financial community to be resolved in the coming months. These include: The role of Wall Street in promoting the now punctured bubble in Internet and technology shares—remember the Chinese wall between securities research and investment banking? The precipitous fall of Enron and its implications for fair and complete financial disclosure, selling by insiders, the independence and accuracy of auditors, the management of employee pension funds and other matters of corporate fiduciary responsibility; and Accounting principle questions and government data issues relating to the proper measurement of corporate profits, productivity and inflation. The strength of the U.S. capital markets derives from the willingness of our society to address these tough issues to provide a more transparent, more responsible and more stable investment environment. Stratigraphic Asset Management, Inc. Investment Outlook—Previous Period