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Past Commentaries

Current Commentary, Review and Outlook
January 9th, 2002

To My Clients, Friends & Observers:

All is waste and worthless, till
Arrives the wise selecting will,
And, out of slime and chaos, Wit,
Draws the threads of fair and fit.

It’s over, investors of 2001. We’ve graduated, under budget and on time. We called the bottom on September 29 and immediately discounted the recovery of ’02. We did more trading (buying) in the ensuing three weeks than we did in the prior five months combined.

On the equity side we screened about a hundred companies not already in our composite, passed twelve, and positioned four – all midcaps, low P/E’s, strong earnings, significant dividends. We repositioned many equities in our composite at fairly discounted prices. Our equity theme emphasizes total return, capital appreciation and dividend growth.

On the fixed income side we have waded in from the money markets, primarily to corporates, weighing portfolios to an average maturity of seven years, with at least 20% of portfolios maturing in three years. Without sacrificing much in yield that will protect against rising rates in longer maturities from a falling dollar, ebullient money supply, fiscal and monetary stimulus, and potentially rising oil prices. We want cash flow.

Rest In Peace, 1981 - 2001

I did not foresee a year ago that a Fed which had so mercilessly raised rates would atone with eleven consecutive cuts. There is only a 50% chance of another Fed rate cut in January but nil probability of any rate increases this year. The great bull market in bonds is exhausted. Herewith our obituary. It was conceived during the Carter administration, under the Fed Chairmanship of G. William Miller, whose Board started to take seriously the ideas of Milton Friedman (and others) to control money supply and the velocity of money to control inflation. It was born in 1981 during the Reagan administration, Paul Volcker presiding at the Fed. Volcker’s Board refined policy further to emphasize the goal of price stability. That’s continued to date under Alan Greenspan. Of all the social, political and scientific ferment the last twenty years the economic liberation was Prometheus unchained. More people than ever before became "Free to Choose" (a book by Milton and Rose Friedman). The human condition is improved because we have learned and acted accordingly –a shining example of good public administration.

Michael Milken -like him or not, a genius -created junk bonds and leveraged companies that refinanced with equity. Over at Salomon Brothers two other geniuses, Bill Simon and Louis Ranieri, were creating a mortgage backed securities market that seeded whole crops of new financial instruments. Shell-shocked by the prior 10 years of economic wreckage, who could have predicted that the creative chaos underway in the ‘80’s would lead to unemployment of 3.9%, budget surpluses, Dow 10,000, interest rates of 1.75% and more concern over deflation than inflation? The invisible hand was made visible, electronically and instantaneously. The financial globe was an unstaked gold field and new prospectors rushed in relentlessly with new tools. Real wealth, a better standard of living, was created. One has to be grateful to be alive in this age and place and be optimistic for the future. It was the bond market bull that laid the foundation for recovery and the phenomenal, secular bull market in stocks.

That too ended, in year 2000, along with the "peace dividend" in 2001, which contribution cannot be underestimated. What we are left with are financial assets generally overvalued relative to likely near-term growth rates. We are also left with far more tools than we had 20 years ago to monitor, evaluate, and control to a greater extent our economic fortunes. If we use the standard definition of recession as two consecutive quarters of negative GDP then this one will be ending by the time it’s defined. And there is a fair probability that we won’t have two consecutive negative quarters.

Outlook

Housing has remained strong, the result of low mortgage rates and compelling demographics. Ed Yardeni, chief economist for Deutsche Bank Alex Brown, makes the point that Baby Boom II’s need for housing will not come from the existing stock of Baby Boom I, who will live longer than any other generation in history. Many commercial REITs liquidated during the year however, after posting the best asset class gains the year before. That suggests that the best money has already been made in that class.

The auto industry has had two extraordinary years of sales, replenishing the auto fleet, but at low prices and low profits. They’re in for a rough couple of years.

Certain tech sectors will have to work out their obesity. I’m afraid that we may never see many promising technologies realized. George Gilder, the writer, thinker and leading technology guru complained in an op-ed piece in the Wall Street Journal last August that federal government policies were aborting many nascent technologies. He indicts OPEC, internet taxation, arbitrary antitrust enforcement, deflationary monetary policy, and plainly socialistic telecommunications regulations. With the exception of deflationary money policy which the Fed has corrected I would agree with him on all counts. By its policies the government is pruning out all potential profitability from huge capital investments and stifling the realization of complete, interactive, accessible, cheap telecom and internet connectivity. Add up an average household’s minimum monthly expenditures for TV @ $30 (33% commercials), cell phones @ $40 (over and above regular home phone service) and Internet access @ $30 (the world’s greatest free library). That’s an extra $1,200 a year that wasn’t being spent a few years ago going mostly to companies that are predominantly old tech in their industry. The "last mile" of connectivity to the house is restrained by the political clout of the old phone companies. I don’t think this is what Judge Green had in mind when he split up AT&T. Those household costs would be far lower and service far better if the government would get out of the way.

You can lead a horse to water but you can’t make him drink. Government monetary and fiscal policies can encourage or invite investor participation but they can’t force it. Regulatory actions have the power to destroy. There are $2.3 trillion in money market funds looking for a place to work. The function of managerial finance is to identify and enhance profitability, cut costs, gain share, raise prices. Looking around, competition is relentless and brutal, pricing power is generally weak, labor costs are rising. For a company with a 5% operating margin, giving a 2% price discount requires a 67% increase in volume to recover the lost profit, to stay even. Increasing productivity is essential to a strong recovery and we need technology to do that.

The most visible growth in a tech sector is in storage, demand for which is growing exponentially, and which simply cannot be delayed. It is too essential.

OPEC has got to go. The compounds that can be derived from oil are so vast in number and scope that it is a tragedy that we waste it by burning it into the atmosphere. Why do we risk American lives for it? Gasoline could be replaced. The markets will do the rest in controlling crude oil prices. The Germans have had a fleet of BMWs successfully beta testing in LA for three years now burning hydrogen. Hydrocarbon emissions: zero. It would take a Kennedy-esque national declaration of independence from foreign oil by the end of the decade. It is an ambition worthy of America.

Notes

Industrial capacity utilization fell to 74.7% in November. The NAPM Price Index fell to 34.7 in December, down from its peak of 78.5 in March 2000.

Money supply through November ’01 increased year to year 6.5% for M1, 10.5% for M2, 14% for M3, and was accelerating the last three months. Clearly inflationary and that’s OK.

Oil closed the year at $19.84. Gold at $278.70. Commodities, basic materials, in the DJ-AIG Commodity Index closed at 89 (1991 = 100). This index appears to have bottomed and bears scrutiny. Nominal inflation in November was 1.9%.

Communist China enhanced its version of Social Security by giving participants some discretionary investment authority. Russia completely replaced its regressive, unwieldy, complicated tax system with a simplified flat tax resulting in a boom of compliance and revenues. The Russian economy is finally rebounding, strongly.

The agency that collects analysts consensus, First Call, predicts S&P 500 earnings growth of

–22% in 2001 and +16% in 2002.

The rate of obesity in American children increased 50% in the 1990’s. (MSNBC)

Targets for 12/31/02: DJIA 11,542; S&P 500 1,274; NASDAQ Composite 2594. On the yield curve we forecast a 1.5% Fed Funds Rate, a 5% five year note and a 6.5% ten year note. Positive indicators of stable growth.

New slaves fulfilled the poet’s dream,
Galvanic wire, strong-shouldered steam.
Then docks were built, and crops were stored,
And ingots added to the hoard.
But, though light-headed man forget,
Remembering Matter pays her debt:
Still, through her motes and masses, draw
Electric thrills and ties of Law,
Which bind the strengths of Nature wild
To the conscience of a child.

The poem is "Wealth" from the book Conduct Of Life by Ralph Waldo Emerson, 1860

Best regards,