Market Commentary – February 2003

Having progressed about half way through the quarter’s earnings reports, I am altering my view that the market remains severely overpriced. That judgment is true as determined by the price earnings ratio on the S&P-500, still about twenty-eight times earnings, but the reported number is skewered to the high side by many companies with losses and the high price of its high technology components. For most stocks, the price is neither high nor low, but some where in the middle. I am finding one company after another with a PE ratio in the fifteen to eighteen range, neither attractive nor notably unattractive. What I am not finding is bargains. After such a severe bear market, this is disappointing and unusual. Every bear market in memory has generated great buys, so the absence is not encouraging for the market. From these observations, I draw a number of conclusions.

First, the direction of the market will be determined by whether or not the economy comes back and earnings advance. Off a low base, profits have jumped back, but at a level far under the previous peak, and there is no sign that the economy is picking up to serve as a basis for further gains. The majority of companies continue to warn of slowness. In each of the last two years, the experts assured us of a second half rebound, and it didn’t happen. Will it this time? Who knows. Optimism about a pick up seems to be based less on solid evidence than the feeling that an upturn is inevitable after such a long period of slowness. On the other hand, the economy looks slower from a long term perspective. One industry after another is losing out to foreign sources. Sometimes the company is merely contracting out its manufacturing and profits do not suffer, but domestic jobs do. The latest I have come across is furniture. We are winning the arms war, but losing the economic war.

Also suggesting non-growth is a worldwide trend is to flatness. It started in Japan long ago, and for years Europe has failed to achieve a sustained pick up. Why not us? The Fed has shot its bolt, though it could simply print money. The administration shows little interest in programs to boost the economy, rather it is using the need for help as an excuse for more tax breaks for the rich. Not much stimulus there.

Second, forget the talk of Iraq war fears holding back the market, that is baloney. The economy is what counts. Will Iraq help or hurt the economy? Again, who knows. One thing for sure, we will pay the full cost of this war and its aftermath is going to be very expensive, so no war is probably the best alternative. And the market seems to do better when there is hope for no war or a coalition war. If we do get war, the already declining dollar will weaken, foreign money will continue to come out of our market, and deficits are going to explode (they already have). Sooner or later, that will lead to higher interest rates, not exactly a help to the economy or the markets. The Bush administration’s international aggressiveness introduces a new equation to the stock market, and it is not likely to be a positive one.

Third, if the bear market is over, any recovery is apt to follow the pattern of recent months: a hesitant back and forth movement. Major bottoms of the past, 1932 and the end of 1974 come to mind, were made because stocks had gone down too much and were extremely cheap. On both occasions, the economy remained weak, but prices had reached an extremity of valuation, and stocks went up regardless. That is not the case this time. As I suggest, stocks may be close to fairly priced, but they are not cheap, the norm at the end of a major bear market. As a result, any recovery in stocks will be gradual.

Finally, I see nothing in the technical pattern to suggest that we have entered a new bull market, therefore as a believer in the trend, I have to presume that we remain in a bear market. New bull markets identify themselves by broad based strength. On a stock by stock basis, bad news has little affect because stocks are washed out and ready to go on favorable news. In recent months we are still experiencing disasters of the day. The market does not look right, and when you wonder why, there is no difficulty finding reasons. I never try to guess the economy, I look at what the market is doing and assume the economy will take the cue. The present cue is stagnation, with a high risk that the outcome will be negative because there is no indicated trend change.

The non-taxed dividend proposal is the most interesting new front for investors. Double taxation of dividends has been around for a long time without harm to the economy, and the timing for a change is terrible since it provides only minor stimulus at the cost of adding to a soaring deficit. But our economy seems to need help, and the Bush proposal may indicate a movement toward comprehensive overhaul of the tax code (I think Bush is reckless, but that is not all bad). Making dividends non-taxable to corporations, rather than to individuals, would be a telling move, so that in its present form the proposal is not all that bold. If the benefit went to corporations, they would increase dividends significantly, at ultimately greater benefit to stockholders, earnings would get a considerable boost, and the stock market would probably recover. Moreover, the preference for debt to equity would be substantially reduced and balance sheets improved, a plus for the bond market as well (though a lot more stock coming into the market is negative).

The present proposal has not been well received, even by Republicans, but resistance may work out best. Once the debate is under way, the benefit might be shifted to corporations. In turn, that would mean such a loss of revenue at a time of mounting deficits that the entire tax code would have to come under review. The Bush idea has stirred the pot, maybe something unexpected will happen.

Although we are unlikely to get the fully untaxed dividend, we will get something. Investors were already looking at dividends as a surer way of making money in stocks, and whatever we get will further stimulate interest.

Our stocks have been in a strange pattern since the October low, particularly this year. We ran way behind the sharp upmove in early January, then did much better than the market once it sold off. That pattern continues on a day to day basis – we don’t do much on the big up days, but decline only slightly, sometimes even have a small gain, on the big down days. Since downers have predominated in the last three weeks, we look OK. But the pattern is strange. I think it says we are in the right stocks, that the rallies have been led by the wrong stocks, and if this market ever gets straightened out, with sound stocks going up and speculative ones trailing, we will do well. If a third bottom in the range of the August and October lows holds, we should get another strong rally. If so, I have solid candidates warming up in the bullpen that have not been bought because the market looks so bad.

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