It was a dismal quarter.  The S&P 500’s 3 month decline exceeded that of Q4 1987 (which included the October stock market crash,) leaving the S&P 500 down 29.0% YTD, the NASDAQ down 39.9%.  From the March 2000 peak, the S&P 500 is down 46.6%, the NASDAQ down 76.8%.  In July, investors withdrew a record amount from equity mutual funds, only to see an August rally erase nearly all the losses.  However, the increasing probability of war between the United States and Iraq, took the major averages back to the July lows by quarter’s end.

Given the most conservative estimates of forward earnings growth, in the context of the lowest interest rates since 1958, the S&P 500 is undervalued by at least 30% (at the March peak, the S&P 500 was overvalued by about 30%.)  Investors remain pessimistic (perhaps overly so) about the following issues:

Corporate accounting standards

Of the 900 US companies required to swear to the truthfulness of previous SEC filings, only 17 CEO’s were unable to comply.  These 17 companies include companies previously under review for accounting fraud such as Enron and Worldcom, plus a handful of companies in bankruptcy proceedings.  No new accounting frauds have been discovered since the spring, although several companies such as Qwest and Nvidia are under review by the SEC. 

Over the past few months, we’ve seen executives of Adelphia Communications, WorldCom, Tyco and most recently Enron paraded in handcuffs, and it appears to be just a matter of time before the SEC charges Martha Stewart with insider trading.  The accounting firm of Arthur Anderson, which featured prominently in several accounting scandals, closed its doors recently, wiping out the invested capital of all its partners.  These events are a wake-up call to any companies with “aggressive” accounting standards; as a result, management and auditors are becoming very conservative.  In the short term, this development means that companies are unwilling to provide “guidance” on forward earnings and earnings growth will be lowered for several quarters.  In the long term, improved quality of earnings will allow investors to make better investment decisions. 

Earnings growth in general

Final earnings growth in the S&P 500 for the Q2 2002 was 1.3%, the first gain in six quarters.  Despite an uptick in negative pre-announcements the past few weeks, earnings are conservatively estimated to grow 7-8% in Q3, 13-15% for Q4 (from First Call.)  These estimates are derived from the universe of analyst estimates, adjusted downward for analysts’ generally optimistic bias, and correlate well with actual results.  There were a number of pre-announcements in recent weeks lowering growth estimates (for example, Walmart forecasts revenues up 3-4%, instead of up 4-6%) but the trend for revenues remains up.  Earnings up, the economy growing, stocks at low values – this is generally a prescription for higher stock prices.

Terrorism

US and allied forces have made enormous strides against the Al Qaeda network.  Recent captures of senior Al Qaeda members in Pakistan disrupts the planning and execution of further attacks.  Money flows to the terrorist network are reduced, although not eliminated.  Neither Osama Bin Laden nor Ayman Al-Zaqahri, the chief architects of Al Qaeda, have been heard from since December; each passing month makes it more likely that both were buried by US air attacks against Tora-Bora.  However, over a dozen low-grade terrorist attacks have been carried out since 9/11 by cells throughout the world, and another dozen thwarted, so vigilance must remain high.

War with Iraq

The prospect of this war is the single biggest drag on stocks right now, trimming perhaps 15% from the value of the S&P 500 while pushing the price of oil from $25/barrel to over $30.  On Tuesday, stocks rallied over 4% on word that UN inspectors had worked out details of new inspections.  However, these gains retreated Wednesday and Thursday as doubts arose about whether the terms of new inspections would be acceptable to US officials, and the US Congress prepared to vote on a resolution authorizing military intervention.

On balance, we believe dethroning Saddam Hussein would substantially boost US security by removing a potential supplier of chemical, biological and, within a few years, nuclear weapons to terrorists.  Although Hussein, a secular dictator, and Al Qaeda, a militant Islamic organization have little in common, both share a hatred of the US which could translate into a second 9/11 type attack on US soil. 

It is very hard to predict the outcome of wars; who on December 8^th, 1941, could have predicted how Germany and Japan would be defeated in World War II.  However, the fear that war with Iraq will somehow “destabilize” the Middle East, is overblown.  Many Arab nations are obliged by domestic politics to speak against US intervention, but most, starting with the Kuwaitis, would welcome Hussein’s downfall.  It would be helpful to have the support of Russia, China, France and Germany in this venture, but not necessary.  Not to be cynical, but France and Germany are the primary suppliers of “dual use” medical and manufacturing equipment to Iraq.

The track record of US military forces in the Middle East is solid.  In the first Gulf War, US ground forces routed Iraq’s army from Kuwait within 100 hours and overran Afghanistan, a country that fought off the Soviet Army for ten years, in three months.  Iraqi forces might fight longer to protect home territory, but Iraq no longer has an air force, US and British planes have flow thousands of missions against Iraqi air defenses since 1998 with no losses, the latest model Iraqi tanks date from 1968, and the average Iraqi soldier is an ill-fed, ill-equipped conscript. 

Iraq is not even a unified country; at the outbreak of hostilities, Iraq could splinter into the Shi-ite South, Sunni Central and Kurdish North section.  Hussein’s loyalists come primarily from the Sunni Central region; both the Kurdish and Shi-ite regions rebelled after the 1991 war, but were brutally suppressed by the central government.  It’s quite possible that Basra in the Shi-ite South could be captured almost immediately, giving US forces re-supply options from the Persian Gulf and securing an airport within 30 minutes flight of Baghdad (Iraq is a little larger than New Mexico, with about the same climate and terrain.)

No doubt, the US forces would experiences casualties (263 deaths in the first Gulf War, several hundred so far in Afghanistan.)  Loss of life is never desirable, but now that we now know giant bull eyes have been painted over the civilian populations of New York, Washington, Los Angeles, San Francisco, Chicago and Boston, we have to be pragmatic about losses.

Bearish factors for this quarter:

Continued worries about terrorism and the war with Iraq

Economy growing, but more slowly than ideal

Bullish factors for this quarter:

Low and stable interest rates

Inflation negligible given low capacity utilization, low commodity prices (other than oil)

Despite worries, consumers continue to spend

Salutary effect of seeing white-collar criminals in handcuffs

Lowest stock market valuations since September 1998, many solid companies trading at 52 week lows

Our strategy is as follows:

Hold tight to cash on hand, take tax losses through year end as warranted, stand ready to buy stocks if it truly seems that this 2 ½ year bear market, the longest since 1939-41, is coming to an end.