"One of the striking features of the past five years has been the domination of the financial scene by purely psychological elements. In previous bull markets the rise in stock prices remained in fairly close relationship with the improvement in business during the greater part of the cycle; it was only in its invariably short-lived culminating phase that quotations were forced to disproportionate heights by the unbridled optimism of the speculative contingent. But in the 1921-1933 cycle this "culminating phase" lasted for years instead of months, and it drew its support not from a group of speculators but from the entire financial community. The "new-era" doctrine-that "good" stocks (or "blue chips") were sound investments regardless of how high the prices paid for them-was at bottom only a means of rationalizing under the title of "investment" the well-nigh universal capitulation to the gambling fever."

-Attributed to Benjamin Graham and David L. Dodd, Security Analysis (1934)

Messrs. Graham and Dodd are considered the deans of security analysis. If one were to insert 1991-2000 into the above excerpt from their seminal work on investments, their observations would be no less true almost three quarters of a century later. History does tend to repeat itself, as many investors have painfully learned over the past few quarters. The destruction of wealth has been widespread, but it has been particularly severe among those who were swept along in a manic fervor into technology stocks and their primary arena, the Nasdaq market.

Professional money managers and more than a few individual investors, especially those entangled in aggressive growth and technology stocks, must be feeling like Charlie Allnut, the crude, irreverent, tramp steamer captain played by Humphrey Bogart in the classic film, The African Queen, set in WWI Central Africa. At one point, Bogart, in his valiant effort to transport the prim, persistent heroine, Rose Sayer, so masterfully portrayed by the beautiful Katharine Hepburn, was forced to pull his mired boat while chest high in a wretched, leech infested swamp. At painful intervals he crawled into the boat so that he and Hepburn could salt off the leeches that sapped his strength, only to again ease back into the dark water to continue his quixotic quest with the full knowledge that those dreaded parasites would again ravage his body. For many investors, the parasites of poor performance have indeed cropped up like leeches, sucking the lifeblood out of their portfolios. And for several quarters, each interval that appeared to offer an end to the bloodletting was followed by yet another period when investors jumped back into the water only to be drained of their resources as company after company issued more distressing news on revenues and earnings.

RECOVERY, RECOVERY, WHERE'S THE RECOVERY?

The pain inflicted upon investors who have clung to the hope of a recovery in technology and aggressive growth has been severe and long lasting. As the accompanying table demonstrates, there have been few ports in which to take refuge. For growth funds, the word "growth" has temporarily lost its meaning. Value investors have fared much better. Stocks that were more reasonably priced had less risk of experiencing dramatic falls, and they have benefited from money inflows as investors fled the carnage unleashed in tech-land. As we begin the third quarter, plaintive inquiries of "When will the market recover?" have grown louder and more frequent. From our vantage point, we see a need for continued caution as well as the existence of selective opportunities.

"It ain't over 'til it's over." At least that is how Yogi Berra would probably describe the current state of affairs in the major market indices. During April and May of this year, investors experienced a respite from the bear market that began in the popular indices in March 2000. But the June market swoon is evidence that old fears were resurrected and new ones emerged concerning the faint pulse of the economy's heartbeat. It is quite possible that in the months ahead the major market indices will continue their seesaw action as investors grapple with the issues that have plagued them for several quarters.

In spite of a very aggressive Federal Reserve that has lowered interest rates a full 2.75 percentage points since the beginning of 2001, the economy has continued to lose traction. At the end of May, industrial production had fallen for eight consecutive months. As prospects for an economic recovery have been pushed further into the future, stock prices have come under renewed selling pressure. Fed watching has been replaced by heightened uncertainty as to whether interest rate cuts will outweigh a dire earnings environment. While a limited number of companies continue to do reasonably well, corporate profits have declined dramatically over the past twelve months. Profits for the Standard & Poor's 500 companies for the quarter ended June 2001 probably declined over 17% compared to the same period a year earlier. This would be the worst year-over-year decline since the third quarter of 1991, when S&P earnings declined 17.9%. Some clouds do have a silver lining. Past quarters of S&P profit decline-the second quarter of 1991, -24.2%; the first quarter of 1982, -20.1%; and the first quarter of 1975, -21.2%-occurred at recessionary troughs. What remains unclear and is exasperating corporate executives and market participants is whether or not the profit picture will begin to show any improvement in the near future.

Consensus thinking on Wall Street (an oxymoron?) calls for an S&P 500 earnings decline of 5.5% in the third quarter. First Call, an earnings research service, looks for a more disappointing decline of at least 13%. The erosion of profits in non-technology manufacturing and a profit implosion in tech-land is dramatically revealed by capacity utilization rates. At the end of May, the total capacity utilization rate for all manufacturers had sunk to 77.4%, an 18-year low. For technology manufacturers, utilization had plummeted to 70.3%, its lowest reading since 1975. In almost nightmarish fashion, the Nasdaq's price decline of 60% over the past year has matched the horrific bear market of 1973-1974 and parallels the plunge in technology capacity utilization.

Not surprisingly, the most dismal performance in profits, or more correctly, record losses, has come from the technology sector. Two of high-tech's former bright stars epitomized the depths of the tech bust. During the second quarter, Cisco Systems stunned investors with the revelation that it would incur $3.4 billion in non-recurring charges for the first quarter, the major part of which was for the write-down of relatively new, but now technologically obsolete inventory. That action appeared to be a coup de grace for the markets until mid-June, when Nortel Networks, the Canadian telecommunications equipment maker, shocked Wall Street by announcing that it would have one of the largest quarterly losses in history, a staggering $19.2 billion, mostly from writing off goodwill arising from acquisitions that, in retrospect, appear ill-conceived at best.

It should be noted that the severe profit slump for technology has overshadowed a somewhat less gloomy picture for much of the rest of corporate America. Technology now accounts for 11% of S&P 500 earnings, down from 15% in 2000. The rest of the S&P 500, in the aggregate, is suffering a less draconian fate and will see a profit decline of just over 7% in the second quarter.

IS THE SUN PEEKING THROUGH?

In a more positive vein, evidence is growing that inventory liquidation by a number of industries is tapering downward. This development, in itself, will foster increased production and business activity in many industries as they replenish depleted inventories. However, there will not be a rapid and robust recovery in many sectors of technology and communications equipment because of the sizable excess capacity that was created during the capital-gorged mania that culminated in the speculative blow off in the stock market during 2000. These industries will continue to struggle to return to a more positive growth trend. But it would be foolhardy to expect a return to the hyper-charged and illusory growth that they recorded in the late 1990s. The excesses unleashed by the flood of capital and speculation attendant to the technology and Internet mania will probably take at least several more quarters to fully unwind.

On the other hand, chief executives of cyclical industries that are heavily dependent upon the consumer such as autos, housing, home furnishings, and retailing are warily eyeing the deteriorating health of the job market and the level of consumer confidence. In addition, they are concerned about the consequences of the reverse wealth-effect spawned by the stock market decline. Interest rate cuts have certainly made the cost of purchase of high-ticket items more affordable. And although it is doubtful that many taxpayers have stayed awake all night mapping out plans for their $300 tax rebates, nevertheless, the tax cuts and rebates -as puny and delayed as they will be-should have a somewhat salutary impact on overall consumer spending. At some point the Federal Reserve may feel that it is pushing on a rope if consumers and businesses do not ratchet upward their spending plans. But much like the chicken and egg analogy, the question of which will come first hangs in the balance. The end-users of goods and services must increase their propensity to consume and order products before business activity picks up in a meaningful way. And until consumers start loosening their purse strings more willingly, businesses will play it close to the vest in terms of employment and spending, which in turn will contribute to keeping consumers somewhat cautious.

Fortunately, not all of the news on the U.S. economic front is so ominous. In fact, recent reports hint that some of the economic clouds are lifting. With some signs of stabilization, if not buoyancy, beginning to appear in the economy, corporations may be set to claw their way back to a profit uptick. The key to a recovery may rest largely with consumers. Consumer confidence in June rose to 117.9, its highest level since December 2000. Home sales and durable goods orders also advanced in May. However, another measure, the overall expectations index, indicates that consumers are more positive about economic conditions six months in the future than they are of the present. The growth in jobless claims appears to have slowed down. Despite some signs of consumer hesitancy, an unemployment level (4.1%) which is still relatively low by historical standards coupled with these recent, positive tea leaves reveal a consumer who is not about to halt spending as abruptly as many economists had feared. Consumers may also be taking some solace from the fact that in most regions, real estate prices have been trending upward as stock indices have been heading south. Thus, the ingredients for a Fed-sparked recovery may well be coming together, although consumers' high debt levels could hamper the recovery causing it to be a more sluggish one than those of recent years.

It is not only the United States that is faced with an economic slowdown. Japan, under recently elected Prime Minister Junichiro Koizumi, though showing promising signs of a willingness to begin a long struggle to unfetter itself from the entangling ropes of decades of stultifying government and corporate economic restrictions, remains semi-moribund and in recession. Europe is held back by central bankers who worry about inflation in the face of global deflation and socialist bureaucrats intent on protectionism at the expense of individual liberty and economic growth. The slowdown in the U.S. is taking its toll on Japan and Europe as well as in the underdeveloped world that is heavily dependent on the U.S. for absorbing their imports.

WALL STREET TURNS INTO BAWL STREET

It is small wonder that the markets have not been an overly hospitable place for investors given the plethora of conflicting economic signals emanating from home and abroad. In the face of such a wide disparity in the barometers of the economy, skittish investors have watched stock prices jump about like a wild hare. This volatility has exhausted the spirit of professional and individual investors alike. Among the stewards of financial television, a decided loss of lilt seems to have developed. Even Maria Bartiromo, the CNBC poster girl for the tech bull mania, seems to have lost some enthusiasm for the daily tug of war waged by the denizens of Wall Street. The IPO market has shriveled like a withered vine. It just does not seem like the game is as much fun.

Perhaps it was inevitable, but in recent weeks, the Wall Street investment banking and analyst community has come under fire for their lack of objectivity in projecting corporate revenue and earnings estimates that were-EGAD! -misleading. How shocking that brokerage firms thriving on revenues from corporate finance/investment banking had an exaggerated, bullish bias when representing these same clients to the investing public! Without question, many abuses occurred in the capital markets over the past few years, just as they have during previous periods of investor contagion. Some of the worst abuses of the recent past will be spotlighted, and some, but not many, scoundrels will be duly punished in some symbolic or more meaningful way (i.e., monetary recompense). Such showcasing of high profile miscreants will doubtless be followed by a legion of attorneys who will clog the halls of justice in their efforts to salvage the savings of the "innocent lambs" so recently sheared by the wolves of Wall Street. We do have compassion for the few truly innocent souls who may have been victims of financial fraud and deception. But you will pardon us if we have little sympathy for investors, professional or laymen, who smile when the sun is up but curse when it rains and then blame their fates on someone else. Caveat emptor had been relegated to the dustbin over the past few years. Investors, young and old, inexperienced and those who should have known better, threw caution to the wind and chased ephemeral riches in a classic bubble of speculation played out in a global electronic casino. People who would not expect a watch they purchased from a hustler on a street corner of Manhattan to last more than a year somehow expected financial houses of cards to pyramid to the sky. There is an old adage on Wall Street, "Bulls make money; bears make money; pigs get slaughtered..." One should not expect others to save their bacon if they overindulge at the feeding trough.

OPPORTUNITY IS KNOCKING

Despite all of the turmoil and dashed dreams of the past fifteen months, in the midst of the disasters du jour that marked the daily investment struggles, a number of companies have seen their stock prices creep irregularly upward. We think this trend will continue. If one remains paralyzed by the flameouts that are littering the tech landscape and weighing down the major stock indices, one will probably forego rewarding investments that exist elsewhere. The markets will always fluctuate. But one's ability to predict the short-term market direction on a consistent basis should be viewed with a healthy skepticism. However, as we have observed many times in the past, the investment markets almost always present investors with some undervalued securities. Today such opportunities among the world of corporate giants appear to be somewhat less plentiful and fruitful. Consequently, the major market indices will labor to move higher. At the end of June, the S&P 500, weighted by each stock's market value and thus heavily skewed by a handful of very large corporations, was trading at about 23.5x earnings, not an especially inexpensive benchmark. However, the median price/earnings ratio of the S&P 500 was 18.3x, indicating far more compelling value lower down the corporate food chain. We contend that there are and there will doubtless emerge many individual companies that do and will offer compelling investment opportunity. Investors should bear in mind the following highly favorable factors that bode well for the future stock prices of well-selected securities, if not immediately, in the not too distant future.

** Stock prices for many well-capitalized and stable businesses have come down quite dramatically and already reflect much, if not all, of the worst economic news that impacts them.

** Measures taken by the Federal Reserve to increase the money supply and to lower short-term interest rates appear to be underestimated by a large number of investors. The eventual impact of a series of Fed actions should be very positive. Interest rates should remain low and possibly move lower. Lower interest rates grease the wheels of economic commerce and result in a relatively favorable environment for stocks.

** Energy prices have come down significantly from their recent peaks and should not escalate dramatically in the foreseeable future.

** Corporations cannot aggressively raise prices, as they must contend with excess capacity. This is true domestically and internationally. Lower energy prices and timidity in overall pricing will provide insurance against inflation. Low inflation is good for asset prices.

** The tax cuts will begin to work their way through the economy, particularly among the manufacturers of consumer goods.

** On the regulatory front, a less hostile Department of Justice, Federal Trade Commission, and Federal Communications Commission will provide a more hospitable background for mergers and acquisitions. Business combinations will likely accelerate due in part to the elimination of goodwill accounting in mergers.

Like a coiled spring, the economy is geared for a rebound, with stocks set to anticipate the probable recovery. Investors often forget that stocks are traditionally a leading, not a lagging, indicator of economic growth. Finally, there is yet another factor that once ignited by one or more catalysts should stimulate a more positive environment for stocks and bonds-namely, sidelined cash. The damage to investor psyche caused by the decline in stock indices and the collapse in the Nasdaq, in particular, may well be offset by a very promising though yet to be unleashed reservoir of buying power. Investors have been liquidating technology and aggressive growth stocks and transferring the proceeds into mid- and small-cap stocks and bonds. But the primary recipients of funds from this reallocation process have been money market funds. Money market funds recently hit $2.1 TRILLION, the highest level relative to the Wilshire 5000 Index on record, surpassing the previous relative percentage record of 1982, a period when interest rates topped 15%. Readers may recall that 1982 was the start of a record and long-lasting bull market. Today, with money market rates dipping below 4.0%, investors, either still in shock over their net capital losses, or skeptical of the prospects for economic and stock market recovery, have kept socking away their cash as stocks have headed lower. Eventually, this dam of liquidity will burst and a sizable portion of these record-setting funds will be flooding back into the stock and bond markets. Combined with very high short interest levels and the sizable decline in margin debt from its peak of last year, the fuel to fire a sustainable stock price recovery has explosive potential.

We were struck by a statement made in a recent BARRON'S Roundtable interview by Archie MacAllaster, a well-known money manager, "If markets were rational you couldn't make a living." Irrational greed and fear breed opportunity. Certainly this is the case more often than not in the financial world. We have often said that you rarely do particularly well in the investment world over long periods of time by doing that which makes you overly comfortable. To be too comfortable is to be complacent or to move with the herd. We think one should have well-measured conviction based on solid fundamental analysis while recognizing that investing in today's environment, just as it almost always has been the case, will subject one to periods during which stocks are propelled erratically in the short run, alternating between waves of euphoria and the crush of fear. Today we appear to be in one of those periods where returns are reverting down toward more historical norms. The expectation of achieving 20%+ annual returns is giving way to the far less ambitious goals of breaking even (a feat beyond the grasp of most ardent speculators of the last couple of years) or making a "decent" return, however nebulous such a goal may be. We think this is a healthy development.

As you head to the mountains or to the beach this summer, take a few good books and do not turn on CNBC. Bogie and Hepburn, after a treacherous journey, eventually experienced an unexpected and heroic ending, but it took a while. Yogi's timeless malapropism seems especially fitting today. Indeed, it ain't over. The economy will bedevil investors until it begins to give clearer, more sustained signals of progress. But a positive upturn seems a question of when, not if. We are sanguine that the outcome of the market's internal struggles waged between the bulls and the bears will yield positive results for those who keep their eyes on the fundamental bearings of the economy and companies. A large number of investors have grown so comfortable with their hoards of cash, in spite of declining money market fund rates, that it may take a while for them to develop the conviction that it is once again safe to enter the investment stream. They may be somewhat late to the forthcoming market and economic recovery, but they will eventually return. Investors who have an eye for value will be carefully wading in the water well before the crowd shows up for a swim.

BEAR TRACKS

% Change Through June 30, 2001

Roger E. King, CFA
Chairman and President