Client Letter - 3/31/03

March 31, 2003

To Our Clients and Friends:

Nearly every press report we see about the stock market these days attributes its performance, whether up or down, to the war in Iraq. That could be right, in the very short term, based on the emotional ups and downs that drive mass-market psychology. However, with a time horizon of more than just a few weeks, it is corporate earnings and the overall economy, not the war, which will continue to drive the markets.

For example, it is not the war that has caused corporate CEOs to curtail capital spending for the last three years; it’s not the war that has caused increased unemployment and consumer sentiment that has fallen to its lowest level in ten years; it’s not the war that has caused consumer credit to reach new (and very dangerous) highs; and it is not the war that has caused housing starts to fall. These are all signs of an economy, burdened with the excesses of the late 1990s, that continues to teeter on the brink of a double-dip recession.

Nonetheless, stocks remain historically expensive, despite a market correction that has been ongoing for more than three years. The price/earnings ratio (P/E) of the S&P 500 index, based on trailing 12 month earnings, is above 30, compared with historic norms of less than 20 (during the last gulf war it was 18). This valuation dichotomy continues, despite the fact that the predictability of corporate earnings growth in the United States is the lowest in more than 60 years (since 1941 and another war), based on statistics kept by Merrill Lynch.

These are not statistics that signal the start of a new bull market. On the contrary, they quite forcefully indicate that the valuation bubble of the late 1990s is still with us, and that this condition must be corrected before a sustainable move up in the market can begin.

In his recently issued annual report, Warren Buffett made the following observation:

“We continue to do little in equities…. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us…. The aversion to equities that (we) exhibit today is far from congenital. We love owning common stocks--if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pretax returns… we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity."

Like Buffett, we too love owning common stocks, but we insist on buying them at prices that will produce acceptable long-term returns. Our own intensive valuation work tells us that the time is not yet right, even though we thoroughly dislike accepting 1% yields while we wait. However, by holding short-term treasury securities, we are very confident that the capital of our clients is being preserved for the moment when stocks again become attractive.

Best regards