The stock market rally of the last 12 weeks, which lifted the S&P 500 5.1% higher and the NASDAQ 15.0% higher than before the 9/11 attack, leaves the major averages slightly overvalued given current interest rates and expectations about corporate earnings.  As we wrote in our last letter, we had positioned our accounts in August in anticipation of a return to economic expansion following the Fed Funds cuts of this spring.  The 9/11 attack postponed that recovery by a couple of quarters, but already there is evidence of an upswing.  With a couple of exceptions like Boeing, we stayed put with our stock allocations as of September.  Our clients were rewarded with a substantial upswing, unfortunately, not enough to deliver positive results on the year.

Obviously the world is a more complicated place than investors had previously realized.  The first phase of the “War on Terrorism” has gone exceptionally well.  US forces were only just getting into position when we published last quarter’s report.  In less than three months, the pro-terrorist government of Afghanistan was routed, a friendlier government installed, al-Qaeda training camps destroyed, thousands of al-Qaeda soldiers captured or killed, funds frozen, and sleeper cells arrested.  Most al-Qaeda leaders have evaded capture or death so far, but their ability to inflict further attacks is sharply degraded.  The US won major propaganda victories in the speed at which Afghanistan was taken (the expected famine deaths of a million Afghanis can be averted by humanitarian aid deliveries) and by steam-rolling over the supposedly invincible Taliban with only 8 American fatalities.  However, the pervasive Middle Eastern hostility towards the US will prevail for years.  Turning this opinion around will require a bridge building effort for which American diplomacy is ill equipped.

Domestically, the US is still coming to terms with the new realities.  Airline security is only modestly improved so far.  The United States borders are still wide open to illegal immigration and weapons smuggling.  Civil libertarians oppose the implementation of advanced surveillance measures and national ID card systems.  The source of this fall’s Anthrax attack, whether domestic or international, is still unknown.  Bottom line, the US remains vulnerable to future terrorist attacks. 

Bearish factors for this quarter:

• Projecting corporate earnings growth for this quarter and all of 2002 is extremely challenging and is dependent on a resumption of sales growth.  Should this growth fail to materialize, stock prices will most likely decline.
• Interest rates are at the lowest levels since 1961.  Interest rates peaked in 1981, and their decline over the past 20 years allowed price/earnings ratio of the S&P 500 to expand, which enabled stock prices to grow faster than growth in the underlying earnings.  Flat or higher interest rates will cause stock prices to grow in line with or below growth in earnings.
• The US budgetary surplus is now history.
• Saber rattling between Pakistan and India, conflict between Israel and Palestine could escalate into region wide war. 

Bullish factors for this quarter:

• Investor money is starting to flow back into stocks, out of government bonds. 
• Stocks generally rally in advance of economic recovery; 11 Fed cuts since January, and a sharp increase in money supply growth argues that economic recovery is close by.
• The “Economic Stimulus” packages under discussion in Congress failed to progress into law.  It’s just as well since these particular packages would have most likely increased the deficit with little benefit to people most harmed by the downturn.
• The stock market overall rarely declines two years in a row (last time was during the 1973-4 recession), let alone three years in a row (last time was 1939-41 at the tail end of the Great Depression, onset of World War II.)

Our strategy is as follows:

Keep our focus on economically sensitive stocks while maintaining our usual 25% allocations to technology, healthcare and financial services.  Invest our cash balances (which currently average about 9%.)  Avoid government bonds.