In a near replay of last year's first quarter, and despite improving company fundamentals, the first three months of 2005 provided little satisfaction to equity investors. Earnings growth remains above average for an economic expansion that started about four years ago, fueled by continued productivity gains and generally positive economic conditions worldwide. Even oil prices above $50 per barrel have yet to crimp profit margins for most businesses, although it's pretty clear that investor anxiety on this issue, plus the rising inflation risks and the Fed's seven interest rate increases, are responsible for much of the stock market's weakness so far this year.

Most indices and investors posted modest losses at the end of the quarter, save those who emphasized the oil patch. We are increasingly skeptical of opportunities in that sector, noting recent stock price performance, shaky fundamentals (rising inventories and supplies, slowing demand), and few oil company executives willing to commit substantial expansion capital based on current spot prices. Tactically, like many others, we regret not fully participating in energy's sharp rise during the past year, but at this point, we believe our longer-term strategy will yield a positive payoff.

We have spent the past few years analyzing the strengthening fundamentals - cash flows, balance sheets, and competitive positions - of many businesses we have long admired yet which failed to meet our strict valuation criteria. The typical valuation premium these stocks once commanded has vanished, offering a unique opportunity for our clients. Over time, we expect the market will once again award a premium valuation to those companies with such strong financial, management, and market characteristics, and so we believe the prospective returns will be quite satisfactory from current levels. As our long-term clients know, our investment style leans more toward the marathon rather than the sprint; this style has proven its worth in the firm's nearly three decades of business.

With market dynamics little changed in recent quarters, it's worth revisiting some broader themes we've discussed recently. In our last commentary, we examined the debate over the trade and budget deficits, and the relative value of the U.S. dollar. We argued that a variety of factors - a broadly improving fiscal situation, relatively better performance of the U.S. versus other major economies, demographics, and the strength and liquidity of U.S. financial markets - were supportive of a strengthening U.S. dollar over the long-term. In fact, the dollar has rallied nicely in recent months following its two-year swoon. But investor angst over the relative long-term health of the U.S. economy continues, particularly in light of the current Social Security reform debate. Our previous note merely suggested the demographic issue in passing, but considering its primary influence in the current Social Security discussion, a more in-depth look is warranted. Furthermore, the misinformation on this subject seems to provide yet another excuse for investors to fear the U.S. financial markets, so it makes sense to examine the actual facts in more detail.

The best recent treatment of this issue we've read is Fewer by Ben Wattenberg, a senior fellow at the American Enterprise Institute who previously worked for presidents Carter, Reagan, and Bush I, and who has excellent credentials on demographic issues. The book offers a fascinating review of some very surprising world population trends: while it's been clear for some time that population growth is slowing, recent UN data revisions imply a smaller, older world population that has important implications for economic and other relationships across the planet.

Wattenberg specifically focuses on recent data revisions by the UN Population Division: because of rapidly falling Total Fertility Rates (TFRs) in almost every country, particularly less developed countries (LDCs), world population will peak at around 8-9 billion in a few decades and then actually decline for the first time since the Black Plague 650 years ago (there are about 6 billion of us on the planet today, but the new projections are much lower than previously assumed). The TFR is essentially the average number of children born per woman over her childbearing years; a TFR of about 2.1 represents the "replacement rate" in modern countries (i.e. 2 children to replace aging parents). TFRs are declining for lots of reasons: urbanization, education, more women choosing to work, the high costs of raising a family, contraception/abortion, etc. Among Wattenberg's most important findings and conclusions:

• The TFR for LDCs has dropped from 6.2 to 2.9 in the past fifty years, as billions of people in places like India, Indonesia, Brazil and Mexico migrate to the cities and have fewer children. Thus, population growth in these countries is plummeting. The TFR in China is now below replacement levels, at about 1.7.
  


• In wealthy nations such as Japan and Europe, an already low TFR has fallen further, to about 1.3. This implies, for example, that Europe's population will decline by about 18% or about 130 million people by 2050.
  


• The situation in the U.S. is unique: the TFR is about 2.0, probably due to better economic conditions, "suburbanization" and a growing Hispanic population. With immigration (more than the rest of the entire world combined), the U.S. population should continue to grow at a healthy pace (from today's 285 million to more than 400 million by 2050).
  


• Aging populations: the data ensure that most countries will experience rapid population aging as people live longer and there are fewer births. In the U.S., the median age will rise from about 35 to 40 by 2050. But in Europe and Japan, median ages reach 48 and 53, respectively. China will, unfortunately, become old before it becomes rich; by 2040, researchers expect it to have an age structure similar to present-day Florida!