Today, as was true during those dark days of the 1930s and 1940s, there is much fear in the world, and it has permeated the psychology of almost all investors, especially in the U.S. After two years of declines, the S&P is in negative territory for 2002 as summer begins. But in many ways, the problems of the stock market are psychological. At a point in the economic cycle when it would be typical for investors to be more optimistic about an economic recovery, and thus more aggressive in bidding up stock prices, they remain uncharacteristically cautious. Both in the U.S. and abroad, investor hesitancy is palpable. Recent figures from the American Association of Individual Investors reveal a marked increase in bearishness that rivals or exceeds comparable levels reached at previous periods of significant reversals in the direction of stock prices. Short sellers who bet on declining stock prices are becoming increasingly emboldened. CNBC no longer draws the big crowds in the lounges at the airport. Institutional investors argue over every little wiggle of the economic data that crosses the tape while ignoring the ever more positive trends developing in the U.S. and global economies. In the twelve week period ended June 7, the S&P 500 declined during ten of those weeks.

Enronitis has spilled over to numerous companies, industries, and their accountants. Wall Street is under siege for its complicity in aiding and abetting the captains of industry who lined their pockets at the expense of shareholders and bond investors. Corporate profits declined for a record five consecutive quarters through March 31 and there is much skepticism about the robustness and profitability of any recovery. And superimposed over the bursting of the tech and telecom bubble, the hubris of corporate executives and conflicted analysts, and the vaporization of corporate profits is the overhang of the potential for disruption that might arise from terrorism. Memorial Day weekend was cursed with the fear that some great landmark would be the latest victim of nihilistic sociopaths. And the anxiety about a possible dirty atomic weapon, engendered by conflicting signals issued by a government that seems to be wrestling with itself to determine how to come to grips with the global and domestic demands of the war on terror, elevated already existing fears. Lastly, the turmoil in Israel and Palestine has been forced to page two while the major powers try to keep India and Pakistan from engaging in yet another war with possible horrific consequences.

It is no wonder that investors are concerned. But the bear market of the major indices and the virtual crash of the NASDAQ over the last two years have done much to address the financial imbalances of the late 1990s. And the increasing recognition that terror is a world and not just a U.S. problem may yield positive consequences that last for many, many years. Bearish gurus now predict a long winter for stocks. Where have they been since March 2000? The NASDAQ has already been in an abbreviated ice age. Stocks that sold for triple digits are now in single digits or in bankruptcy. For the first time in recent market history, the yield on the stocks of major pharmaceutical companies is now greater than the yield on Treasury bills. The yields on many utilities that will survive and prosper long after the shockwaves sweeping through the merchant energy industry fade are greater than the yield on 30-year Treasuries.

The low volume in the stock market in recent weeks is both a sign of sellers who have become exhausted and have little stock left to sell as well as a fear on the part of potential buyers who feel better earning 1.31% in a money market fund (a 30-year low) than taking on the risk of buying stock that might appreciate by double digits over the next two or three years. And all the while, cash keeps building, and is well over $4.0 trillion.

Investors have become so frozen by front page news and the constant hammering of negative pronouncements floating over the airwaves that they not only fail to see a glass that is half full, they see it as empty. Yet, recent economic developments are signaling a rebound in economic activity that will soon be followed by higher corporate profits. The Chicago Purchasing Managers Index rose to 60.8 in May from April's 54.7, registering its best reading in over three years and handily beating most economists' expectations. The University of Michigan Consumer Confidence Index jumped to 96.9 in May, from 93 in April. First quarter productivity growth was a dynamic 8.4%, the best since 1983. The Institute for Supply Management's national manufacturing purchasing report for May was a healthy 55.7, compared to 53.9 in April. And General Motors, a proxy for the old economy, raised its estimates for earnings in 2002.

The ubiquitous fear of a plunge in the U.S. dollar is overdone. The dollar will probably continue to decline. But a weaker dollar will lift U.S. exports and depress imports, which should boost GDP. Multinationals that have been hurt by a stronger dollar should benefit. Higher import prices should give greater pricing power to domestic manufacturers. It is interesting to note that after a rise similar to the past few years, the dollar declined almost 20% during 1985-1986. During the same interval, inflation slowed from 4% to 2% and bond yields declined from over 11% to under 7%. The S&P 500 rose by 35%. Yes, every period is different, but a dollar decline may not necessarily lead to a significantly negative chain of events.

In short, not only is the glass half full, but it appears to be gradually filling with ever more good news. Liquidity is again growing and federal government expenditures and a very healthy consumer are contributing to economic growth. Business investment is showing signs of coming to life as well. At present, the federal funds rate, expressed in real terms (i.e., adjusted for inflation), is essentially at zero and the yield curve is fairly steep. Whenever a similar situation existed in the past, a very strong economic recovery ensued. We believe the economy will continue to recover in the second half of 2002 and into 2003. Corporate profits will follow and stocks will begin to discount this eventuality. Stocks that are presently languishing in the face of complacent short sellers and deer-in-the-headlights investors should experience quite handsome returns.

An economic recovery with solid fundamentals has already started and is progressing, albeit at a slower pace than more optimistic observers had hoped would be the case. A strong first quarter GDP number should be followed by a rise in overall corporate profits for the first time since the final quarter of 2000. At this stage of an economic recovery, the S&P would typically have experienced a significant gain from its lows of last year. Yet it remains in negative territory for 2002. The NASDAQ is even worse, down 21% through June 7, with other key indices down modestly or showing only small increases.

What ails Wall Street are psychological factors that transcend mere economics. Faced with terrorism, the threat of nuclear conflict, and "dirty bombs," investors have cowered on the sidelines. As if international uncertainty were not enough, the issues of earnings quality, complicit accountants, Wall Street conflicts, and greedy and corrupt managements have shaken investors' confidence in a level playing field.

Most of the problems stemming from corporate governance, accounting, and the quality of earnings and impartiality of investment research are being addressed. The focus of investors on these matters has already started the inevitable process of eliminating many of the worst abuses of the whole system of accounting, corporate governance, and investment banking which underlie the financial and research reporting upon which investors rely. The drag on the equity markets from accounting irregularities and corporate deception will gradually fade from having a meaningful impact on securities prices as their underlying causes become footnotes in financial history.

On the international front, while cognizant of the great differences in the world today versus periods in the past, there is also reason to anticipate a shift in psychology. There is a growing recognition among most leaders that a world of terrorism is a dark world for all mankind, not just the "Satan of the West." Behind the scenes, progress is being made globally against terrorists and their sponsor states. In South Asia, both India and Pakistan have lowered their rhetoric and artillery exchanges after pressure from the U.S. and other western nations, as well as China and Russia. Progress is slowly being made with respect to the Israelis and Palestinians as President Bush has recently proposed the creation of a Palestinian state.

With regard to Iraq, it is increasingly evident that the U.S. is preparing to "take out" the Saddam Hussein regime. While potentially a source of fear, such action could lance a major boil in the Mideast equation. If we deal with Iraq, it would put increasing pressure on Iran and Syria to shift away from well-known support of terrorism. Without the sustained support of Iraq, Iran, and Syria, the Israeli/Palestinian conflict may be easier to resolve.

Most of the assumptions on Iraq are based on a conventional assault from the Persian Gulf area. But suppose U.S. forces, now more closely allied with Russia and former Soviet republics, were to project power from the north of Iraq while supporting the Iraqi Kurds, who are no friends of Saddam. Hypothetical? Of course, but it may pay for investors to recognize that the issue of terrorism is not without novel solutions. At some point it is highly possible that the forces of evil are overwhelmed by the forces of good as well as by some very effective military might projected from distant corners by the strange bedfellows which world events often create.

If the geopolitical center moves back toward normalcy, a great psychological cloud will have been lifted from the minds of investors. We have no way of knowing what the international scene may hold in future months. But over long periods of world and American history, it has never paid to assume only the worst will occur in the future. The equity markets, in turmoil over an economic downturn exacerbated by a new kind of war, have been declining for 27 months, longer than the 24 month bear market of 1973-1974, which was a far more difficult economic period than exists today.

Certainly there is risk in the markets today. There always is. Yet stock markets sometimes fall even if investors' perceptions about the economy are wrong and fundamentals are clearly improving. The dark headlines on both the economic and geo-political front will eventually give way to more optimistic overtones. The rewards to investors over the next few years should be rewarding ones indeed, even though they might not provide the pyrotechnics of the grossly speculative period of the late 1990s. Perhaps the catalyst to ignite investor hope and greed will be the promising crop of second quarter earnings releases to come as well as a more optimistic guidance about future prospects from corporate leaders.

Thus far, 2002 has been a difficult environment for stocks. We at KING are especially disappointed with the firm's results in January and early February. As we have stated previously, the investment staff here also owns many of the same stocks that our clients own, so we too are sensitive to this year's downturn that was primarily compressed into the early part of the year. We want to assure our clients that over the past few months we have taken measured actions to address the anomalous period of earlier this year. Part of this process has entailed a restructuring of client portfolios as well as enhancing our sell discipline so that we minimize losses before they can become too excessive.

To recap the events of the beginning of the year, client portfolios were negatively impacted primarily by our exposure to the wireless and cable TV industries as well as the poor performance of one individual stock, Elan, an Irish pharmaceutical company. Importantly, these events transpired over a very short period of time. We certainly believe this string of events to be an aberration; they do not represent the firm's full capabilities and are not reflective of the firm's long-term performance history. Essentially, we have sold all of our positions in the pure wireless industry. The fundamentals of the industry changed, and they changed very rapidly. The possibility for a turnaround appears to be slim over the next several quarters. One of the key reasons for purchasing these companies was the belief that the customer base served and the spectrum owned by each company was worth a significant amount of money. While this may still prove to be true, this value will not be realized anytime over the next year or so. Most of our cable holdings were also sold at much higher prices than where the stocks trade today. There certainly is value in certain companies within the group. However, when the negative and alarming news came out regarding the Rigas family's under the table dealings with Adelphia Communications, a shadow was cast over the entire industry, as many cable companies, including Cablevision and Cox, are primarily family controlled. While we believe the Adelphia situation to be isolated, we exited most of the cable stocks in early April (at prices approximately 25% or so higher than today) as we believed that investors as a whole would shoot first and ask questions later. Elan was also sold- accounting issues or not, perception is reality in this market. Due to this factor as well as several delays in their drug pipeline, we viewed the risk in the stock as too high.

As a result of these sales and others which were made to take profits on stocks that had reached our price targets, we have freed up capital that has been reinvested into companies where we believe the downside to be limited, the upside promising, and the valuation to be very intriguing. For the most part, these new purchases are companies with fairly clean balance sheets and less leverage. Adhering to our Business Valuation Approach, which has proven to be so successful in the past, we are finding very attractive companies in a variety of industries. In recent months we have made purchases in the healthcare, financial, energy, and consumer staples industries. After all of the turmoil and carnage of the last couple of years in the broader market, we believe there are many unusually compelling investment opportunities available. As an example, many large-cap companies, which had been too expensive over the last few years, have now declined enough in price to meet our buy criteria so that they may be purchased in our multi-cap accounts. In these accounts, we have purchased positions in some large-cap healthcare companies. This marks the first time in six years or so that we have had a greater representation in these and some other large-cap stocks in our multi-cap portfolios. Because many of our newer clients have not previously seen these larger-cap stocks in their portfolios before, they have asked if this marks a change in philosophy or strategy for the firm. The answer is an emphatic no. We are very opportunistic and will go where we see value, regardless of the market cap size of the company. Many higher quality names such as these had been too expensive as a result of the powerful rally experienced in the late 1990s. It has not been until the last six to nine months that many of these companies started appearing on our radar screens and they are now at levels where we believe the risk/reward to be very attractive. Of course, we continue to see potentially rewarding opportunities in the mid- and small-cap universe as well.

The necessary repositioning undertaken over the past few months is starting to take hold. After underperformance at the start of the year, our relative performance for most clients bottomed in February. While on an absolute basis we are down a greater amount since the end of February, we have been performing more or less in line with the market (the overall market has been down; the S&P 500 declined in ten of the twelve weeks through June 7). Our longer-term goal is not simply to perform in line with the broader market, but to add value and produce long-term returns that are superior to the overall market. We believe that we are very well positioned to rebound going forward and are cautiously optimistic about generating healthy returns for our clients, just as we have over many years in the past. Importantly, this recent period of underperformance has been over a relatively short period of time, and we believe that over time, we will return to our historically positive form.

Unfortunately, we have been through similar periods in the past. Most money managers will at some point experience a period of time when the market turns against them or their investment style falls out of favor. Often these periods are short, but painful, in duration. Managers must be flexible and make necessary changes to correct any problems which might exist, but the biggest risk to clients is that their manager give in to temptation and change his or her style in order to make things work over the short-term. This can often prove to be extremely damaging to long-term performance. We should emphasize that we are not changing our style. Using our investment philosophy, we have fundamentally analyzed those stocks which were problematic and taken action based on those results. All new portfolio additions were also chosen according to our Business Valuation Approach.

Clients who have been with us for quite some time will recall that we have historically recovered rather nicely after a period of underperformance. Again, this is why we believe that it is imperative to look at performance in the context of long periods of time. Decisions to hire a manager after unusually strong short periods of return or to terminate a relationship after short periods of underperformance frequently work against the long-term goals of an investor. Since we have grown over the years, we now have many new clients that have just experienced their first major downturn and have a very short history with which to compare. While no one likes to experience the sort of downturn that has occurred during this bear market, and while we can never predict the future, historically our clients have been rewarded handsomely over the long run. We believe this will be the case in the future as well.

In addition to ongoing portfolio adjustments, we have also improved our sell discipline in order to minimize the portfolio effects of overly precipitous declines in individual securities. We continue to utilize our three primary reasons for selling a stock-a change in fundamentals, more attractive alternatives exist, and/or a stock meets its price target. And we are incorporating a new technical enhancement. Importantly, we have analyzed our performance over the last several years and our investment process-the Business Valuation Approach-has been very successful. It is rare that we purchase a stock and then see it decline dramatically shortly thereafter. The vast majority of the time, we have made sound stock selections. However, we believe it would be an improvement to exercise greater discipline in taking money off of the table after a stock has had a nice run and nears our price target. Likewise, we will be more proactive in trying to keep individual security losses from becoming too great. Fundamental considerations will continue to be a key factor in our decision making process. However, a stock will become a candidate for sale if it falls approximately 10% to 20% from its moving average relative to such market indices as the S&P 500. Again, this will not be the only driver of a decision to sell or prune a stock, but is a tool that we will incorporate into our investment process to help us limit the downside risks of our investments.

We expect our turnover to be quite a bit above average this year, and then to reverse back to a more normal range in 2003. The average stock is now held about eight months by U.S investors, down considerably from the multi-year holding periods that were prevalent in the past. The nature of the markets is such today that it is very difficult to achieve good returns with a pure buy-and-hold philosophy. Aggressive mutual funds, hedge funds, and other market participants increasingly create significant volatility and exaggerated stock price movements which can either work to an investor's disadvantage or be exploited. In any event, until a prolonged and extended bull market becomes a realistic expectation, the more proactive investor will probably do relatively better in a trading range environment than was the case over the extended bull market of 1982 through 2000.

We are optimistic about the future and believe that our efforts will yield very healthy long-term performance. We appreciate your continued support and always welcome any questions you might have.

Roger E. King, CFA
Chairman and President

Leah R. Friday, CFA
Senior Vice President

Ryan McCleary
Analyst

Contributors:

Bloomberg;
ISI: International Strategy and Investment Group, Inc.;
Credit Suisse First Boston