Investors are, for better or worse, prisoners of the times in which they live. And while we would always try to properly direct a client's attention toward time horizons that stretch over decades, the simple fact is that the past few years have yielded measly returns compared to those of the 1980s and 1990s. To highlight the most interesting of dozens of current statistics, the S&P 500 index has gained no ground since 1999, and even a 10% annual return over the next four years would deliver merely a 3.2% compounded return to investors for the first decade of this millennium (the worst since the 1930s). While our accounts avoided the collapse of the growth stocks five years ago, the most recent period has provided different challenges, namely severe compression of equity valuation multiples and low capital market returns for most traditional asset classes. The frustration has only been amplified by company performance that has generally been quite good: corporate profit margins are near peak levels while earnings have grown at a double-digit rate in each quarter for the past 31/2 years. In response to such fundamental achievement, the markets have, on the whole, yawned.

If we can all agree that equity market enthusiasm is still broadly lacking despite the favorable fundamentals, the U.S. economy has suffered a similar indignity. GDP growth has averaged about 4% over the past ten quarters. As economist Brian Wesbury highlighted in a recent Wall Street Journal editorial, during the 2004 election campaign 36% of Americans thought we were in a recession; one year later, with unemployment down from 5.5% to 5.0% and Real GDP up 3.7%, the percentage that believe we are in a recession has risen to 43%. Most remarkably, the U.S. economic engine seems to have lost barely a step in recent months despite a tragic hurricane that disrupted crucial energy supplies (and raised oil prices above $70 per barrel), as well as a Fed that matter-of-factly raised short-term rates for the 13th consecutive time in the past 18 months. Overall, it seems to us that the U.S. economy has performed somewhat better than most expected, yet skepticism remains high. In the past quarter century, however, it has been wrong to underestimate the resilience of this economy.

The late 1990s offer an interesting juxtaposition to the market's current disregard for corporate and economic fundamentals. At that time, we at Harris Associates viewed the equity market as "complacent": the valuations of many "high expectation" businesses - particularly in technology - traded at premiums to our estimates of intrinsic value. As we said at the time, the risks seemed to be very large because investors came to believe the levitation would persist - the market would essentially reach a new type of equilibrium on its way to "Dow 36,000". Yet the hoped-for new valuation paradigm was shattered in early 2000, not by a single event but by a slow unraveling as the emperor's clothes proved elusive; the decline surprised most investors and wiped away years of gains.

Today's lack of attention to corporate and economic fundamentals, on the other hand, feels more like indifference than complacency. This is a distinction worth noting: the growing disinterest in equities as an asset class implies a different set of risks and returns than when investor enthusiasm seemed endless. Most obviously, investors seem to have sensibly ratcheted down their own expectations regarding achievable investment returns: stock price valuations are lower and there are fewer examples of wild speculation. This removes a significant amount of the risk we worried about at the end of the last decade. If anything, today's concerns lean more toward the macro, at least in part because the memories of any type of severe economic disruption are too distant (or don't even exist) among today's investors. As we stated earlier, $70 oil elicited a big yawn, and even the most recent U.S. recession (2001 in case you forgot) was remarkably mild. Excepting that minor economic dip, it's been over fifteen years since the U.S., Canada, Australia, or the U.K. has experienced even a run-of-the-mill recession. It would be very easy to take economic stability for granted these days, except that most investors who actually have a strong opinion about the economy today tend to be pessimists.

In late December many pundits latched onto the recent inversion of U.S. Treasury yields as the key indicator of an imminent recession and equity market downturn (their other main concern has been the well-telegraphed slowdown in the housing market). We would agree that the market's holding pattern is likely to change soon (enough of this already!), but we are not convinced of a negative outcome. The pessimists do have plenty of statistical history to support their argument: over the past fifty years inversions of the curve (i.e. yields on 2-year bonds higher than 10-year bonds) have preceded almost every recession. As the story goes, an inversion can make it more difficult for banks and financial institutions to borrow short and lend long, thus threatening a key engine of economic growth.

While the historical yield curve relationship is difficult to dispute, we are very skeptical of formulating investment policies from these types of correlations. In recent years we have been swamped with similar economic warnings, including the "trade deficit/imminent U.S. dollar collapse" (yet the greenback actually rose in value against most currencies last year), the "inflationary U.S. budget deficit" (long-term interest rates are below 4.5% and core inflation remains near 2%), as well as the dire warnings following Katrina (despite the oil price surge, the economy has not missed a beat). In the case of today's yield curve argument, it's important to note some potential mitigating factors: banks have faced a narrow yield spread for several quarters already, inflation remains subdued, and low long-term interest rates are typically favorable for most investments. Finally, one even wonders whether the unprecedented appetite for long-dated U.S. Treasuries today by foreign investors makes the yield curve indicator meaningless.

In general, normal cyclical economic patterns should not interfere with the realization of long-term value in our portfolios. Our idea of value assumes that businesses exist in dynamic economic environments, and we expect a cyclical pattern to the overall economy. But most important, we're not so sure the economic "headline du jour" has anything to do with equity market returns: the historical record is very mixed (witness the past few years in the U.S.), and it is interesting to note that the strong Chinese economy has produced four consecutive years of decline in the Shanghai Composite Index (it closed 2005 at its lowest level in seven years). So, solid - if not strong - economies do not guarantee a strong equity market, nor do weakening economies mandate poor investment returns.

As our clients know, we are focused primarily on fundamental factors in our effort to uncover securities priced at big discounts to intrinsic value. Often, our attraction to an opportunity is enhanced by the skepticism of other investors who may have a different time horizon or focus, and we are generally comfortable holding a contrarian position that may offer substantial profit. We have NOT decided to become economists, but we are struck by today's economic skepticism that feels much like the doubt we have noted many times in our individual investments: despite many challenges and plenty of doubters, the U.S. economy appears to be on pretty solid footing.

We believe the current market trading range will break in time. Our portfolios, as we have emphasized in recent letters, increasingly reflect the opportunities we see in higher quality businesses. The valuation compression we have previously noted has, if anything, intensified in recent months such that we believe there is little or no valuation premium attached to better businesses (furthermore, ISI Group reports the collapse in P/E ratios is the greatest since 1973-74). While five years ago many of these stocks would have been found in growth-oriented portfolios, at current valuations they represent great opportunities for disciplined value investors like us. And while our enthusiasm for many of these stocks is not unique among investors, we believe there is a broad skepticism - an indifference - that increasingly reflects macro fears more than specific company risks. These businesses possess, in general, healthy balance sheets, strong cash flow generation and valuations well below intrinsic value. We admit an economic downturn is likely at some point, but we also believe that economic strength, like corporate profits, has been underestimated for some time. Furthermore, the link between economic performance and stock prices is tenuous, and our 30-year record has relied much more on company-specific fundamentals than any set of macro factors. Because of lackluster equity market returns for the past few years, it seems most investors have become indifferent to equities in general and better businesses in particular. From our vantage point, the fundamentals look good, the economy seems OK, and the discounted valuations offer great profit opportunities for investors with resolve.

Edward S. Loeb, CFA
Partner & Portfolio Manager