2002 was a stock market “perfect storm”. The market faced a faltering economic recovery, poor earnings, record corporate bankruptcies compounded by exposure of management greed and fraud, not to mention global terrorism, and the threat of war with Iraq. The result was a 22.5% decline in the S&P 500, and the third successive down year (averaging a decline of 14.6% per year). Looking into 2003 we face the specter of deflation, a developing housing bubble, too much consumer debt, and stock valuations high by historic standards. No wonder the stock market is not acting well. 

The current decline ranks as the worst bear market since the depression, but the key is the tremendous number of negatives that are already reflected in the market. Early 20th century stock trader, Frank J. Williams, noted that, “The market is the most dangerous when it looks the best; it is the most inviting when it looks the worst.”

We continue to believe we saw the stock market lows in the August to October 2002 period, and that record low interest rates justify current valuation levels. Near term we anticipate military and economic uncertainties may cause the market to remain weak, but eventually the prospects for an economic upturn and better earnings comparisons will lift share prices. We are also looking at the lowest interest rates since the Eisenhower era, not to mention the fact that only once in its 107-year history has the Dow Jones Industrial Average been down four years in a row. Our only long-term reservation is that the pattern of past secular adjustments from “bubble” overvaluation to extreme undervaluation has taken ten to twelve years. Therefore, we anticipate a choppy environment with modest total returns averaging (+5 – 10%) per annum for the next few years.

Looking beyond our shores, the key question is whether or not the outperformance last year of non-US markets, as represented by the MSCI EAFE index (-15.9 vs. the S&P’s –22.2%), was the start of a trend, or just another flash in the pan. EAFE actually outpaced the performance of the S&P500 4 times during the past 10 years. Despite this, EAFE produced a paltry 2.4% advance per annum on average, compared to the S&P500’s average of 9.3%. Looking at prospective valuations, most EAFE markets are currently attractive relative to the US, particularly when it comes to dividend yield. The notable exception remains Japan, which only appears undervalued on a price-to-book basis; on P/E and dividend yield, the market remains expensive. In aggregate, non-US markets appear to be positioned for modest outperformance moving forward. Should the US dollar continue to weaken, those returns will be higher. 

From a bottom-up perspective, we are focusing on stocks that have several areas of interest and possible catalysts. One example is Fresenius Medical Care (FMS, $15.25) which is the world’s largest, integrated provider of products and services for individuals undergoing dialysis because of chronic kidney failure. Fresenius has the largest market share in both dialysis care and hemodialysis products, and has the second largest market share in products for peritoneal dialysis. Particularly in the US, which is Fresenius’s largest market, dialysis is a growth business as obesity continues to increase, resulting in more cases of diabetes and related renal failure. 

On a more upbeat note, Fresenius has switched almost all of its clinics to single-use only dialyzers, which the company has found to significantly increase patient longevity. Although single-use dialyzers are more expensive than those that are reused, their use has been found to significantly reduce labor costs in Fresenius’s clinics and is helping the company expand its market share. With the cost of transitioning its clinics to single-use dialyzers behind them, earnings are expected to grow at 10% or more over the longer-term. Trading at 10.8 times 2004 earnings, with a 2.3% yield, we find the stock attractive.