The New York Times headline said it all: “A Dismal Quarter Around the World”. The S&P 500 ended the third quarter of 2002 down 18%, and that was better than most overseas markets. It was the worst quarter since the crash in late 1987, and the worst September in 65 years. The only place to hide was cash, bonds, or short positions. We had hoped the late July plunge had set the market low for this cycle, but in fact the indices pushed through to new lows in early October. While disappointing, this is not unusual, as bear markets often test lows once or twice before establishing a solid bottom and moving up. We suspect that the bear market that started in early 2000 will ultimately rank alongside 1929 and 1972 in terms of severity.

We believe there are two key longer-term issues that will determine the direction of the market over the next 2-3 years. The first is how quickly the post-bubble normalization process plays out for the market as a whole. Second, is whether or not we have a multi-year economic hangover from the excessive capital spending of the late 1990’s.

The market continues to react to the weak economic outlook and war risk, but our concern relates to the bubble normalization theorem. Corporate earnings and stock prices tend to move together over time. Every twenty or thirty years a speculative bubble erupts and carries stock valuations way above the normal relationship to earnings. After the bubble bursts, stock prices go to record low valuations before eventually moving back to trend line in tandem with earnings growth and interest rate levels. The real question in our minds is whether or not we have sufficiently overshot on the downside, or if this is a process that will take a few more years to work out. Most bearish observers believe the forty-year average price/earnings ratio of 16 times for the S&P500 must be exceeded on the low side, to ten or less to really make a bear market bottom. We would argue that when this last happened in 1973-1974 the circumstances had a different tenor to them. Then, as now, there were a host of major macro issues to consider. In contrast though, inflation increased to double digits during the 1973-1974 period, whereas we now have record low inflation and interest rates (last 40 years). If we look specifically at periods where inflation is 2% or less, we find the average trough price/earnings ratio was 14 times (source: Morgan Stanley Research). In fact, 14 times the estimated 2003 earnings for the S&P 500 of $54 equals 756 which is very close to the market low in early October. This is consistent with our view that we are now in the process of making a bear market bottom, but it may be another two or three years before we see a sustained upward move in the stock market. In the meantime, modest gains in the stock market should be more attractive than the low returns available in the bond market.

Turning to the economy, our concern is that the vast amounts of capital spent on telecom and internet projects have resulted in huge excess capacity. Will this diminish demand enough to keep our economy, and perhaps even the global economy, in the doldrums? As with any bubble, tremendous economic resources are wasted, but the excess capacity should be consumed in an economic upturn, allowing for a resumption of growth in corporate profits. Key to an upturn is the support of central bankers and politicians; tight monetary and fiscal policies would compound and extend the slowdown, which is what happened in the 1930’s. It is also critical that market forces be allowed to work, wiping out the excesses, which is what has been happening with the internet and telecom industries (unlike the Japanese banking system, which the Japanese government has never allowed to collapse). We have been here before, and it will still take time to work through, but the underlying strength in the world economies will reassert itself. 

We must remember that over the last five years every major region in the world has suffered extreme economic and market pressures, in the process of creating solid bases from which to move forward. As bottom up stock pickers, we know that market duress creates wonderful opportunities for long-term investors. We are focused as always on finding the best companies in growth businesses at reasonable valuations.

As we look forward we believe dividend yield will become important again in a slow growth low inflation environment. Therefore, one of our new ideas is Nicor(30), a gas distribution business in Illinois. Not very exciting but providing a 6% current yield that we hope will continue to grow around 4% per year.