-Attributed to Thucydides,
The History of the Peloponnesian War, 431 - 413 B.C.

During the first week of 2002, most of the world's stock markets continued their upward movement that began after the initial, violent shockwaves that hammered equity prices in the immediate aftermath of the treachery of September 11. After a historically tragic day, the U.S. and much of the world rallied around George W. Bush who became President in deed through a trial of fire like no other that this nation has experienced. The resoluteness of the Bush administration, the prowess of the U.S. military, the indefatigable Rudy Guiliani, the citizenry of NYC and Washington, and the accompaniment of some key allies in dealing with the cancer of terrorism at home and abroad were critical in restoring hope and confidence to a dispirited world.

In retrospect, it appears that September 21 was the nadir for most stock prices and major indices in the U.S. and the world and probably marked the end of the bear market that began in March 2000. After a week of intense volatility and record stock market volume, the thrashing capitulation of fearful sellers gave way to a growing sense of confidence. As events unfolded in Afghanistan and the Federal Reserve kept lowering interest rates and providing monetary liquidity to the financial system, investors became less fearful and more convinced that the economy would begin to recover.

Yet despite the initial successes in Afghanistan and the early indications that the U.S. economy is showing some initial positive signs of recovery, many of the concerns about which investors were worried prior to September 11 still remain. And there are some additional pitfalls that have the potential to roil the markets. Nevertheless, the markets are signaling that perhaps the problems facing our economy are closer to resolution, and that future economic activity will be, if not overly robust, more positive than has been the case for several quarters.

As welcome as the fourth quarter recovery was, for most market indices it was not enough to salvage another difficult year. As shown in the accompanying table, major equity averages at home and abroad posted double-digit declines for the second year in a row. Not since 1973-1974 have the major market indices suffered a two-year downturn. And not since 1929-1931 has a major average been down three years in a row. We do not believe there will be a three-year repeat. As the old Brooklyn Dodgers would have muttered, "Wait 'til Next Year." Well, 2002 is here and we think it will be, if not a great year, a good one. Let's hope we are being too conservative.

In reviewing the mounds of research and prognostications that cross our desks, we are always struck by the disparate and usually well-reasoned opinions as to the future outlook for such things as economic activity, corporate profits, stock prices, and future returns. Before we share our thoughts on the market and the economy, we thought it would be useful to offer our readers two contrasting views about the future outlook for corporate profits and investments.

Doubtless, most of our readers have heard of Warren Buffett, Chairman of Berkshire Hathaway, who is considered by many to be a particularly astute observer of the investment world. At the 2001 Berkshire Hathaway shareholder's meeting, Buffett made some interesting observations about accounting, corporate profits, investment returns, and future expectations that overzealous investors would be wise to contemplate:

Your question about inventory write-offs gets into the category of "big bath" charges which are the tendencies for management when some bad news is coming along to try and put all the bad news that's happened into a single quarter or a single year-and even to put the bad news that they are worried about happening in the future into that year. It leads to real deception in accounting. The SEC has tried to get quite tough on that. But my experience has been that managements that want to do it usually can find some way to do it.

And managements frequently are more conscious of what numbers they want to report than they are of what has actually transpired in a given quarter or a given year....

In the Fortune article [1999 Interview], I talked about the unlikelihood of corporate profits in the U.S. getting much larger than 6% of GDP. And historically, the band has been between 4% and 6%¾and we've been up at 6% recently. So unless you think that profits as a part of the whole country's economic output are going to become a bigger slice of the pie… And bear in mind they can only become a bigger slice of the pie if other slices get diminished to some extent (personal income and items like that).

So I think that it's perfectly rational and reasonable that in a capitalistic society, corporate profits are something like 6% of GDP. That does not strike me as outlandish in either direction. It attracts massive amounts of capital because returns on equity will be very good if you earn that sort of money. And on the other hand, I think it would be very difficult to get where corporate profits would be 10% or 12%¾or something of that sort-of GDP because it would look like an unfair division of the pie to the populace.

[S]tocks are a perfectly decent way to make 6-7% per year over the next 15 or 20 years. But I think anybody who expects to make 15% per year-or expects their broker or investment adviser to make that kind of money-is living in a dream world.

From a historical perspective, Buffett also makes another key observation:

Interestingly enough, some of those same relationships prevailed decades ago. But you were buying stocks that were yielding perhaps 5%. So you were getting 5% in your pocket plus that growth as you went along. And of course, now if you buy stocks, you get 1.5%… So the same rate of growth produces a way smaller aggregate return.

Buffett runs up a red flag for trustees and consultants who are driving forward while looking in a rear view mirror:

[I]t's particularly interesting to me that back when the prospects for stocks were far better…pension funds were using investment rate assumptions that were often in the 6% range. Now when the prospects are way poorer, most pension funds are building into their calculations returns of 9% or better on investments.

I don't know how they're going to get 9% or better on investments. But I also know that if they change the investment assumption down, it would change the charge to earnings substantially-and they don't want to do that. So they continue to use assumptions which I think are quite unrealistic. And for companies with a big pension component in their financial situation and, therefore, in their income statement, that can be quite significant. So it'll be interesting to me, where pension funds are experiencing significant shortfalls from their assumptions in the next couple of years, to see how quickly they change the assumptions. And the consulting firms are not pushing them to do that at all. The consulting firms are telling them what they want to hear-which is hardly news to any of us...

In fact, very few situations exist where people are reducing their assumed investment return. Many major corporations are using an investment return assumption of 9% or higher. With long-term government bonds below 6% and high-grade corporates maybe yielding 7%, they are not going to get the returns they need in the bond market. It will also be difficult to achieve in the stock market. However, it would cause their earnings to go down if they were to change their investment assumptions. It is all just a matter of time before these issues begin to come to the surface.

Buffett's conservatism may be as much a reflection of his unwillingness to invest in technology because, by his own admission, he does not understand it as well as the difficulty he faces in investing the huge sums of Berkshire capital with which he is entrusted. Certainly Buffett's cautionary judgments throw water on the re-emerging hopes of the technology mavens who have pumped newfound liquidity into tech stocks during the fourth quarter of last year. Technology has been a key driver in recent years behind the growth of the economy and, in the latter part of the previous decade, a major part of the rise in the large capitalization market indices. Technology will undoubtedly play an ever-growing role in future economic growth. But it may be some time before the earnings of the leading technology companies lead to significantly higher stock prices than the lofty levels registered in early January. The growth in earnings expected by technology bulls simply does not compute on a macroeconomic basis.

Even more disquieting are Buffett's comments on the ostrich-like behavior of pension fund trustees and actuaries. The day of reckoning cannot be far off when the large number of companies puffing up their earnings through unrealistic pension cost assumptions, based on unachievable bond and stock market returns, must eventually face the music. Sadly, this may be one of the big "surprises" that overly aggressive managers and their complicit consultants unload on stockholders in coming months.

For a contrasting and decidedly more optimistic view of what lies in store, we now turn to some comments from Robert Robbins, Chief Investment Strategist of SunTrust Robinson Humphrey. Robbins is fairly representative of the optimistic camp of Wall Street and has achieved a fair measure of success over a long period of years. He considers himself an unapologetic superbull, and his observations are an interesting counterpoint to the more bearish and cautionary investment camp.

Superbull stock markets have historically been characterized by disinflationary economic growth-neither inflationary economic growth, on one extreme, nor deflation/depression, on the other extreme. Long-term disinflation is very likely to continue, driven primarily by disinflationary monetary policy. There has been no unusual rise in inflation expectations suggestive of an end to the last two decades of disinflation. …[E]conomic policies, mainly monetary policy, will cause annual inflation expectations to decline from about 2.5% to perhaps 1.5% over the next five years. Economic forces seem very likely to result in good growth in the U.S. economy.

The history of the past 100 years of the stock market shows that virtually all years can be analyzed as part of at least three-year trends. Typically, such trends have been either superbullish, with compound annual total returns at least 1.5 times average, or superbearish, with returns less than half of the average, and sometimes in the negative double-digits. …[T]he challenge for those who are not superbullish is to be superbearish, which seems to be a very difficult case to make. We view the most likely superbearish scenario as being a major, sustained cutoff of oil supplies. An oil supply disruption would probably fall under one of two scenarios: (1) a nation chooses to cut petroleum exports to the U.S. by consensus, which seems unlikely because participating oil producers would almost certainly suffer a severe economic depression; or (2) an "undemocratic," or military-related, cutoff that would probably be reversed by the U.S., as in the case of…Kuwait in 1990.

The stock market's decline in 2000 and...in 2001 was largely the result of the Federal Reserve's fight against inflation-the critical factor for continuing superbull stock markets. The Fed raised the federal funds rate to a nine-and-a half-year high (6.5%) despite about a 70% decline in the core CPI inflation rate during that time. Technology stocks retraced about 88% of their previous 18-month advance. In fact [as of mid-December], the S&P 500's technology and telecommunications sectors have lost $3.2 trillion in market capitalization since March 2000, roughly the same as the losses incurred by the entire S&P 500. By contrast, the non-technology S&P 500 now rests only 3% below its level on March 24, 2000, due especially to strength in the finance and healthcare sectors.

Interestingly, at the bear market low in September, technology stocks were still 42% above their 1998 bear market low, whereas the S&P 500 was almost exactly unchanged-hardly evidence that the technology sector's long-term trend is down....[T]echnology has been persistently outperforming the stock market since the apparent end of the bear market in September-a healthy sign for technology and for the stock market, which is about one quarter technology and telecommunications, broadly defined. Finally, the financial sector substantially outperformed during the bear market, indicative that the fundamentally key financial "backbone" of the U.S. economy and stock market has been sound.

Robbins' outlook for the future utilizes a very different crystal ball than that of Mr. Buffet:

We estimate about 19% annual compound stock price appreciation over the next five years, aided by about a 30% bull market recovery over the next 12 months, and then a return to the 16% compound average annual rate of gain for this superbull market over the remaining four years. Our outlook is based on an earnings recovery of about 25% over the next four quarters (above the First Call consensus of 21.4%), resulting in S&P 500 earnings per share of $50.70 during 2002. During the following four years, we expect 10% compound annual earnings growth, plus P/E multiple expansion adding 5.5 percentage points compounded annually. That P/E expansion should reflect superior earnings growth, substantially reduced risk (via reduced economic cycles as a result of the Fed's anti-recessionary monetary policy), and the continued downtrend in long-term interest rates, reaching new multi-decade lows. As such, the S&P 500's current P/E ratio of 26.8 times 2001 earnings of $43.63 (First Call) expanded 5.5% compounded annually would mean a P/E of 34.9 times in five years (this equates to a year-forward P/E of 31.4). Moreover, P/Es may reasonably reach into the 40s during this superbull market, in our opinion. Earnings should continue to benefit from expanding technology and rising productivity.

Our S&P 500 outlook to mid-year 2002 is strongly bullish. We expect the S&P 500 to rise about 20% to 1369, within a range of up 10% to 25%. Stock market gains should be unusually steady, in line with the market's historical tendency to rise nearly every month from the recession low through the three months after the recession's end. Indeed, the bulk of the stock market's gains following a major low occur during this timeframe. …After the last four bear market lows, the S&P 500 rebounded 50% in one to three years. Although the S&P 500 has already rebounded 22% from its bear market low, it would now have to rally 27% further to reach the 50% mark.

Ultimately, we believe that the S&P 500 could achieve 1540 (+35%) by year-end 2002, and that the Nasdaq Composite may rise to 2750 (+37%) during that same time.

S&P 500 BEAR MARKETS SCOREBOARD

% Change Through December 21, 2001

Well, it is always interesting to examine contrasting opinions. We know what most investors would like to believe. But before rushing out to bet the ranch on the rosy scenario presented by the more bullish prognosticators, we would hasten to add that there are also many who predict a more ominous outcome. They look for a continued bear market reflecting an economy hamstrung by consumers overburdened with debt, continued excess manufacturing capacity, rapacious domestic and global competition which limits pricing power and profits, and a drift into deflation as the U.S. is dragged down by weak foreign demand for U.S. goods and services. At the same time it faces a glut of cheap imports originating from cash starved foreign producers that compete with American corporations, especially from Asia and Latin America. Recent tensions in Argentina, Pakistan, and India, the continued Israeli/Palestinian struggle, and Japan's inability to extricate itself from its deflationary spiral further exacerbate a fragile world economy already dealt a body blow by terrorism.

From our vantage point, we suspect that neither the doomsayers, Mr. Buffett, nor enthusiastic superbulls like Mr. Robbins will be correct. The pendulum of future stock market returns will probably come to rest somewhere between conservative expectations of 6% to 7% and more sanguine expectations of 15%, with a reasonable range of 8% to 12%. And before concluding that this is a depressing number, bear in mind that, historically, equities have provided about an 8% to 10% compound annual return over a very long period of time. The power of compounding is a marvelous wonder. If one compounds their capital at a rate of 8% a year, they will double their money every ten years. At a rate of 10% a year, your capital would double approximately every seven years.

We do not side with the doomsayers, because we think they continually underestimate the ability of the Federal Reserve to liquefy the monetary system for as long as it takes to prime the pump of economic activity. Yes, it is possible that they may be pushing on a string, but we doubt it. Not only have they driven down interest rates such that the yield on money market funds is now less than 2%, they have the ability to provide such a significant amount of capital to the financial markets that banks and other lenders find it irresistible to finance new economic activity. As for Congress, as they have so ably demonstrated in recent months, when called upon to spend the economy out of a recession, they have no equal. When faced with the prospect of an electorate uneasy over their economic state, Congress will serve as a willing agent in pork barrel spending to stimulate the economy. Of course, exactly how the spoils of largesse are divided can spark many a public debate over fiscal policy. Recent salvos over taxes and a stimulus package exchanged between Democratic Senator Tom Daschle and President Bush set the stage for the political battle that will be waged during an election year. But there should be no doubt that neither the Republicans nor the Democrats will stand idly by and watch the U.S. slide into a deep recession for which they could be blamed. The downside of the propensity to spend is always that the government is a very inefficient allocator of resources and in the long run contributes to a drag on GDP. We believe lower taxes on income producers will not only result in a higher level of activity but also in greater tax revenues. But that is the grist of politics about which we will all hear too much this year.

The primary reason that we think Mr. Buffett is a wee bit too conservative is that the technological revolution provides the platform for a level of global economic growth that may indeed be somewhat greater than that of the post WWII industrial period. Without question, the frenzy of speculation that surrounded the technology boom, the Internet, and dot.com mania of the 1990s drained a great deal of capital into ill-defined business plans and excessive capital expansion. But that is not unlike similar periods when the world witnessed the expansion of the railroad, steel, automobile, petroleum, telephone, television, and computer industries. There were far more failures than successes in those previous periods of explosive economic activity as well. But the benefits of today's technological and biopharmacy revolutions have only been delayed by the recent excesses, most of which have been wrung out of the capital markets. As the survivors of the first landing on the world's economic stage of broadband, the Internet, wireless, and genetic engineering stabilize and move forward on a global scale, the benefits to world economic activity could prove surprisingly significant.

Mr. Buffett's innate conservatism may explain a part of his reluctance to participate directly in the fruits of technology which are such an important part of the world economy. And it may skew downward his expectations for the future. We would hasten to add that we are not of the "this time it's different" school. In the final analysis, companies must provide an attractive rate of return on their capital in order to merit healthy stock price performance. And Buffett's conclusion that nominal GDP typically grows over time at a rate banded at the top by 6% may be reasonably accurate, if only slightly too low. Yet there will be a large number of companies in older, more cyclical, and less profitable businesses that will pale as investments alongside a group of other companies that are able to benefit from the new era of technology and whose returns on capital are significantly higher and, thus, will indeed take a larger portion of the economic pie.

On the other hand, the reason we think that the rosy scenario crowd may be too confident is, ironically enough, also related to the benefits of technology and economic globalization. We think the broadband and Internet revolution is in its early infancy. Its first stage has witnessed a tremendous wave of startups and now bankruptcies. Yet, its impact is spreading at an exponential rate. As the survivors see the less well-capitalized players fall by the wayside or acquired, they will accrue pricing power and greater profitability. The many manufacturers, providers, and users of the new technology will find themselves in a dilemma. One of its greatest strengths, which is providing efficiency and lowering costs, will present the never-ending challenge of intense competition. From the very simple purchase of CDs, books, suitcases, and PCs, to the more complex, but increasingly pervasive, purchase of industrial goods and services such as steel, newsprint, chemicals, trucking, rail, and shipping, competitive pressures on businesses are intense, and they are international as well. The new technology has made it easier to facilitate economic activity, but goods and services become less proprietary and more commoditized, thus leading to less pricing power. This competitive pressure is disinflationary. By its nature, it will enhance the volume and efficiency of economic activity and, thus, lead to perhaps a greater level of global economic growth than is anticipated by more conservative observers. Yet, it may well constrain the admittedly healthy growth that will be achieved by the producers of goods and services that is anticipated by the more sanguine analysts.

It seems to us that there will indeed be both an old economy and a new economy, with each melding into the other. The old economy will take advantage of some of the benefits of the new technology. That said, it would be hard to envision some highly capital-intensive industries such as mining and minerals making outlandish returns on their capital. But their products are necessary ingredients in the economic equation. From time to time, old economy industries will undergo consolidation where the strong will acquire the weak or watch them go under so that those left standing are able to earn a reasonable economic return. More rapidly growing industries will attract capital more easily and undergo periods of great growth, capital infusion, and the inevitable fallout that comes from the creative forces of the constructive destruction of capital. They, too, will witness periods of greater merger and acquisition activity. Each wave of economic cycles will progress ever higher despite the inevitable ebb and flow of business successes and failures. It is against this background that we remain cautiously optimistic about the future returns that can be achieved by focusing on buying pieces of businesses through their publicly-traded securities.

We think the table is set for a more palatable feast for investors than that provided by the turkeys of the past two years. It will not be champagne and caviar, but there should be many delectable dishes from which to choose. Despite our positive comments about the future benefits of technology, we think the stocks of many of these companies, if acquired at today's prices, will result in some near-term indigestion. It may pay to wait until the actual profits of the tech industry catch up with the dreams of the optimists. On the other hand, we think there are some intriguing opportunities in healthcare, cable TV, broadcasting and entertainment, the wireless service industry, and a host of special situations. Contrarian plays may also surprise on the upside in the financial and energy industries. With many investors looking for the Fed, after eleven interest rate cuts in 2001, to possibly raise rates later this year, they are negative on financial service companies that are perceived to suffer from a rising interest rate environment. We think much of the negative expectations about many financial service companies may have already been discounted. Likewise, with growing pressure on OPEC to maintain oil prices, investors are wary of oil and gas producers and the oil service industry. Here, too, much of the negatives may already be reflected in current stock prices. With the benefit of an accommodative Federal Reserve, lower tax rates, and a government ratcheting up spending, any pickup in economic activity should soon translate into greater energy demand and a more optimistic tone for oil and gas related stocks.

What is most important from our perspective is that investors not project the immediate past into the foreseeable future. The ongoing war against terrorism may yet have more horrific surprises. The economy still has many rough hurdles to cross, including more unemployment and business failures, a debt-burdened consumer, a cautious business community still reluctant to engage in aggressive capital spending and hiring, and a government that spends too freely while it refuses to leave more funds in the hands of taxpayers who would allocate capital more productively. Yet the sizable decline in corporate profits in 2001-the worst year over year drop in decades-and an overly restrictive Fed in 2000 were the main reasons stocks fell so precipitously. The bad news is old news. The good news, and we believe it could be very good, is yet to come. The record inventory liquidation is behind us. Manufacturing capacity utilization should begin to improve with easier profit comparisons to follow. More bankruptcies will result in a more rational pricing environment with a corresponding improvement in corporate profits. Taxes will definitely not be increased. The very low yields available on short-term investments will result in the continued transfers of these gargantuan funds into equity and bond funds as investor confidence grows. In short, it is time to look forward, to hopefully prosper, and to remember what we have learned from the trauma of 2001.

As 2002 unfolded, a thirty-one year old Green Beret from Texas became the first American soldier to die from enemy fire in the war in Afghanistan. He left behind a wife and two very young children, and he joins the other victims of terrorism that we shall mourn for decades to come. He will not be the last to make the ultimate sacrifice to protect all that is wonderful about this great nation and our way of life. For this G.I. and thousands of his comrades before him, we can never be too grateful. His service brings to mind another comment Warren Buffett made, with which we close: "There is nothing dumber than betting against America. It hasn't worked since 1776."

Roger E. King, CFA
Chairman and President