Market Comment February 3, 2003 Monthly Investment Commentary | February 2003Most investors were probably relieved to see the books closed on 2002. That feeling of relief transitioned into optimism as stocks began the new year with a surge and were up 6% by January 14th. But economic uncertainty and fears that war is inevitable cut the legs out from under the rally. By month’s end all equity asset classes had posted losses on the month of about 3%. Investment-grade bonds were flat and high-yield bonds posted a slight gain.Thinking Through the PossibilitiesWhy take any risk now? is a question many investors have been asking themselves. The question is a fair one. After all, the economy continues to struggle, and war, perhaps without the support of the United Nations, seems unavoidable. But in order to answer the “why take any risk” question a thoughtful investor should think through the possibilities, rather than letting their general unease (which can’t help but be influenced by the media) do the thinking for them. With that in mind there are several points that I believe are important to consider.It’s Scary Out There, but There Are Positives TooThere is no doubt that the world is a scary place, especially now. Before even considering Iraq there are plenty of reasons for investors’ confidence to waiver. But in almost every instance there are also reasons to be less gloomy.Excess capacity in a wide range of industries (not just technology) is extremely high. In fact, manufacturing capacity ex-tech has barely rebounded off of a 19-year low (tech is worse off). This suggests that business investment will remain sluggish for a while longer. But, it must be noted that capacity utilization bottomed almost exactly at the end of every recession over the past 35 years. So the fact that there is lots of excess capacity in no way suggests that a strong rebound might not be imminent.Business confidence is shaky, with the Iraq situation exacerbating worries that have led to a wait-and-see attitude on the part of the business sector. This has contributed to the weak labor market. On a more positive note inventories are extremely lean, suggesting that any mild pick-up in confidence should quickly drive increased business spending.Consumer confidence is weak (other than the early 1990s, confidence has not been this low in almost 20 years) and there are fears that spending growth could slow dramatically. Behind these fears is the weak labor market, which is considered the key to consumer spending. Adding to the worries about spending growth are several concerns including: 1) the fact that spending didn’t contract much in the recession implies a lack of pent-up demand; 2) consumer debt levels are at all-time highs; and, 3) the mortgage refinancing-driven spending tailwind may die out if rates don’t go much lower. But there are also several positives to note. Disposable income grew sharply over the past year. And though debt service relative to disposable income is high, it is no higher than it was in the mid-1980s. If we look at median levels, this ratio has been declining and is only barely higher than in the mid-1990s. So far, there is not much evidence that debt service is a problem—loan delinquency rates are comfortably below the 1980s peak level. And, though the stock market decline has reduced household net worth, the fact that wealthier households hold a disproportionately large portion of stocks suggests that the net worth reduction was concentrated in relatively few households. According to a recent Fed survey, median household net worth actually rose since 1998 (as of October 2002) because home prices impact the net worth of a much larger proportion of the population than do stocks.It’s hard to argue that the economy isn’t fragile. But it is not far-fetched to think that a positive surprise or two couldn’t be the catalyst to unleash corporate spending on inventories, capital outlays and labor. But what is the possibility that this could happen in the face of the impending war against Iraq? The odds are probably not high partly because many businesses are taking a wait-and-see attitude given uncertainty of an extended period of higher oil prices and a costly war (and its aftermath). But the possible outcomes of the Iraq situation are not all negative for the economy and investors. The war might go well with a quick realization that, at least on the oil front, there will be no widespread disruptions to the flow of oil. The onset of war and the mere recognition that it won’t be a disaster is likely to be enough to begin to loosen businesses’ purse strings. And there is another possibility that investors are discounting. That is the chance that Saddam Hussein totally backs down or flees into exile at a point when he realizes there is no other way out for him. Some sort of occupation may still follow. But it’s very likely that that outcome would be a huge shot in the arm to business confidence and a positive catalyst for the stock market.So where does this all leave us? Clearly short-term economic risks remain but it does not require irrational exuberance to imagine a markedly improved investment and economic environment later in 2003. Uncertainty reigns again. Accepting this leads to another important question. What risks are already reflected in the price of financial assets? This is a critically important question to consider. Investors cannot make informed decisions by simply assessing the economic risks without considering valuations.Valuations—What Risks Are Reflected in Financial Asset Prices?In my opinion “risky” assets (stocks, REITs and high-yield bonds) are selling at valuations that already take into account much of the short-term risk and some of the longer-term risks. This conclusion is based on a variety of valuation measures using different inflation, interest-rate and earnings scenarios. Late in January I updated the return potential for the mainstream asset classes. My base case is for a 10% annual return from the S&P 500 over the next five years. While a 10% return may not make investors drool, in a low-inflation world it is a wealth-building return that is consistent with longer-term pre-bubble history. Under different scenarios the return could be significantly higher or lower but I view the odds that it will be higher as greater than the odds that it will be lower. Moreover, I believe there is somewhat more potential return in the broader stock market (small- and mid-caps) and REITs over the next five years.The expectation for low double-digit returns does not mean that any of these asset classes could not continue to decline in the near term. Asset classes can become deeply undervalued and stay there for quite a while. That is a possibility in a world that is threatened by war and terrorism while it still strains to recover from the excesses of a bubble that will be written about for years to come. But if we look out five years (and probably much less) it’s highly likely that the economy and the stock market will have recovered, with both again showing their resilience. For those who argue that the stock market has not declined enough to offset the excesses of the 1980s/90s bull market, it is worth noting that the ten-year annualized return on the S&P 500 is now less than 9%. This simple fact seems to support the valuation analysis that concludes the excesses have been purged from stock prices.Of course these forecasts could be off the mark but I believe that equity assets are priced at levels relative to defensive assets (high-quality bonds) that make their longer-term outperformance quite likely. Over the short-run, how the financial markets play out is an even tougher call, but as stated earlier, it’s not pie-in-the-sky to believe that positive surprises will result in a sooner- and stronger-than-expected rebound for stocks, eliminating some or all of the undervaluation.Why not stay very defensive until the Iraq situation is behind us? For investors whose primary concern is minimizing short-term risk at the cost of lower long-term returns that is a reasonable approach. But before long-term investors follow this strategy they should realize that opportunities to invest in stocks at significantly undervalued levels don’t happen often. Taking advantage of undervalued opportunities is how superior long-term returns are built. As I write this I estimate that stocks are 20% to 30% undervalued with the broader market even more undervalued. A positive surprise from Iraq could result in a quick price spike that could wipe out half the undervaluation or more. Investors waiting on the sidelines would miss this move and be faced with the tough decision of whether to invest at a stock market level higher than the one they were previously uncomfortable with. Alternatively, perhaps things go badly with Iraq and the economy and the stock market drops another 10% or even 20%. Obviously then there would be an opportunity to buy in at a lower price—but pessimism will be high enough so that it will still take great intestinal fortitude to do so. And for investors already in the stock market, I don’t believe it is likely that their long-term return potential will be too negatively impacted if things do go badly in Iraq. If this is right, good long-term returns will still be captured even if preceded by short-term losses. My conclusion then is that being overly defensive risks missing out on some of the return opportunity while not doing so results in a likely outcome of being rewarded either sooner or later.You Can Eat Relative PerformanceThere is a saying “you can’t eat relative performance.” It implies that outperforming in a down market by losing less is still losing and in the end doesn’t do the investor much good. For long-term investors the conclusion is off base because it implies that the down period defines the investor’s entire investment experience. For long-term investors that obviously is not the case. Over the long run returns are made up of many shorter return periods including ups and downs. Losing less in declining markets can offset lagging performance in up markets and result in more long-term wealth.Please do not hesitate to contact me if you have questions or would like to review your portfolio.